[Updated with 2012-2013 limits and fiscal cliff deal AMT fix] As part of the fiscal deal Congress has finally put in place a permanent fix to the Alternative Minimum tax (AMT) that will help prevent millions of tax payers paying the higher AMT tax rate. Legislation that makes up the fiscal cliff deal permanently adjusts AMT income exemption levels to rise with inflation, while giving lower-income taxpayers more access to credits like the child tax credit. Indexing the AMT provides tax payers with certainty on their tax rates and liability rather than waiting for Congress to enact an AMT patch each year.
In 2012 the AMT exemption level is $50,600 (singles) and $78,750 (married). For 2013 the AMT exemption level is $51,900 for singles and $80,800 for married couples filing jointly.
The AMT is complex, but it basically has two tax rates and inflation adjusted income thresholds used to figure out one’s AMT liability. For 2013, the AMT imposes a 26 percent tax rate on the first $179,500 (vs $175,000 in 2012) of income above the exemption levels shown above and 28 percent on incomes above that amount. The AMT exemption phases out at a 25 percent rate for AMT taxable income above $115,400 (singles) and 153,900 (married couples). In 2012, the phase out levels began at $112,500/$150,000 (single/married). The phase-out creates effective AMT tax rates of 32.5 percent (125% of 26 percent) and 35 percent (125% of 28 percent) for affected taxpayers.
How the AMT works
Everybody should pay their fair share of taxes, right? It would be difficult to find somebody who doesn’t believe that but in reality it’s not that simple. The tax code is a complicated document which gives rise to a number of loopholes that are widely known (and used) by the nation’s wealthy as well as corporations in the United States.
In contrast, if you’re a low or middle income earner, it’s much more difficult to reduce your tax burden. Of course most people don’t like taxes but they understand why they have to pay them which is what sparks a little bit of outrage when they learn of some of the nation’s rich getting some big tax breaks.
Not all of the nation’s rich have a problem with paying their fair share, though. Noted investor and one of the world’s richest men, Warren Buffet, believes that not only should the nations rich pay their fair share and more, he offered to prepay some of his tax burden to the government totaling nearly $3 billion!
For the rest of the nation’s rich who aren’t as forthcoming with their money as Mr. Buffett, the tax code includes a vaguely understood tax called the alternative minimum tax, or AMT which tries to ensure that the “rich” are taxed appropriately.
What is it?
For the nation’s rich who can write off a lot of their income, the alternative minimum tax assures that regardless of their deductions, they will always pay a minimum amount. Think of it as an alternative set of tax rules that go in to effect for those people who qualify for special tax benefits. It was originally designed to affect just 155 Americans. Now, it may potentially affect tens of millions.
There’s a reason it has made the news for the past few years and it has nothing to do with the small percentage of the population that qualifies as the nation’s rich. The AMT is now affecting more and more middle income earners, despite Congress making multiple increases to the exemption amounts.
Why the Middle Class?
For those of you with a few years under your belt, think back to what was considered filthy rich in 1969. You would probably agree that “rich” was a lot less than what it is today. The reason that the AMT is now affecting middle class Americans is because the IRS has never adjusted the AMT tax for inflation (until the fiscal cliff fix discussed above). According to the IRS, what was rich in 1969 is the same amount as it is today.
How many will be affected? According to one study, 31 million Americans will be affected this year and if you make between $75,000 and $100,000, you might be one of those who have to pay over and above your normal tax rate.
How much is the hit?
If your income is above the AMT exemption levels (see table below), there are a different set of rules and rates for figuring your taxes. E.g. The AMT tax rates start at 26% and cap out at 28%. In contrast, regular tax rates start at 10% and cap out at 35%. Secondly, a host of tax benefits and deductions (like state taxes) that are available under the normal tax rules are not available if you fall under AMT rules. In other words, far less deductions and a higher effective tax rate!
The AMT exemptions are phased out by 25% of the excess of alternative minimum taxable income (AMTI) over $150,000 for married persons filing a joint return and surviving spouses, $112,500 for singles. Estates and trusts also face AMT and their exemption level remains unchanged at $22,500.
In reality the only way to really figure out if you owe the AMT is to do your taxes twice – once with the AMT rules described here and under standard (1040) IRS rules. I recommend you use some good tax software to help you or if your return is complicated, I suggest seeing an accountant.
If your tax liability under the standard tax rules is higher you don’t need to worry about the AMT tax rates. But if your taxes under the AMT rules and exemptions are higher, then you need to pay extra, making up the difference between the standard and AMT tax liability.
For a detailed breakdown and to calculate your specific AMT liability I suggest you use reputable tax software or visit the IRS website and complete their AMT tool or use the worksheet in Form 1040 or 6251.
Here are two basic examples to show how AMT works:
Let’s assume that you do your taxes and calculate your tax at $35,000. In contrast, your tax under the Alternative Minimum Tax rates is only $31,000. Since the AMT is lower than the normal tax, you are not subject to the AMT.
What if you calculate your tax under traditional tax rules to be $35,000 but under AMT rules, your tax is $39,000? You fall under the AMT rules and you have to pay the $39,000. To make it painfully simple, the government will take the highest of the two amounts.
How Can I Avoid the AMT?
The realistic truth is that it’s very difficult – unless you are happy to have an income below the exemption amount. Some people time their quarterly tax payments, only claim certain deductions, and, with the help of their tax advisors, employ other strategies but for most it’s not an easy task.