Understanding Alternative Minimum Tax (AMT)
Calculating your income is only the first step in determining your take-home pay, or your net pay. The next part involves adding in deductions and credits which lower what you have to pay. Some high-income earners can add enough deductions to significantly reduce their tax bills — and potentially push them into a more favorable tax bracket. To ensure these high-earners pay their share of taxes, the government sets an alternative minimum tax (AMT) rate.
Because of the Tax Cuts and Jobs Act (TCJA) of 2018, only a fraction of all taxpayers had to consider the AMT. The number of affected households dropped from five million to less than 150,000 the following year.
Still, AMT is very much a concern among plenty of taxpayers, especially those that are on the border of taxable income brackets. Here is what you need to know about AMT from a money-management perspective.
What Is the Alternative Minimum Tax (AMT)?
The first version of the alternative minimum tax debuted in 1969 and was known as the “millionaire’s tax.” This is because the IRS discovered that 155 millionaires didn’t pay any taxes because they took advantage of deductions and credits that lowered their overall tax bill. The goal of this tax was to make sure the wealthiest Americans still paid their tax bill.
The AMT was then adjusted during the Reagan administration (the Tax Reform Act of 1986) to provide more exemptions and deductions for the wealthy and then again with the TCJA in the Trump administration.
After reaching a certain earnings threshold, taxpayers are required to run a series of calculations to factor in the AMT. The taxpayer will look at the AMT tax bill compared to their standard tax bill and pay the higher amount.
The AMT calculations vary from standard models by adding certain costs to the tax bill while eliminating deductions that filers can apply.
How Does Alternative Minimum Tax Work?
The alternative minimum tax is based on your total reported income. You have to hit certain earning thresholds to qualify to pay the AMT and pass beyond certain exemptions. The more you earn beyond this threshold, the larger your federal income tax will be. This is considered a progressive tax, as opposed to a proportional tax or regressive tax. Essentially the idea is your taxes will stay proportionate to your overall earnings for the year. Therefore, if you stay in a lower income bracket, your taxable percentage remains low as well.
If you’re on the borderline of an income bracket, you can lower your overall tax bill to avoid entering this AMT earnings threshold. For example, you can contribute a higher amount to your 401(k), which will reduce your reported income levels. You can also pay into a health savings account (HSA) which can also give you increased healthcare coverage.
Calculating Alternative Minimum Tax
A trusted tax professional or financial advisor can help you understand whether you need to pay AMT and how you will do it. However, you can follow these steps to estimate whether you will be responsible for AMT on your upcoming tax bill.
- Calculate your taxable income. If you earned $75,900 as a single filer or $118,100 as a married couple filing jointly, you will have to pay AMT.
- Determine your tax rate. If your income falls below $206,100 as a single filer or married couple, your tax rate will be 26%. If your income falls above these thresholds, it will be 28%.
- See if you qualify for any exemptions. The more your annual income, the higher your AMT. Exemptions are phased out to 25 cents on the dollar for people who earn more than $539,900 for single filers and $1,079,800 for married couples as of 2023.
- Complete your tax forms. If you suspect that you owe AMT, complete Form 6251 which can be found on the IRS website. Your accountant can also help you with this.
- Pay your tax bill. Once you complete your tax forms, you should have a clear idea of what you owe. This can also help you budget your taxes for next year.
The thresholds for AMT change each year. Check to see the limits for single and joint filers for 2024 before you assume that you will have an AMT bill.
Who Is Responsible for Paying the Alternative Minimum Tax?
Calculating your tax bill isn’t as simple as submitting your W2. As you grow your wealth and become a “high-earner,” through investing, your taxes will become increasingly complicated. Without realizing it, you might hit the AMT threshold if you aren’t aware of your various deductions and tax options.
Therefore, stay confident as you pay your taxes. You don’t want to overpay more money than you owe, but you also can’t risk underpaying. The IRS could request additional money, levy fines for misfiling, or even start the auditing process to review your income.
If you manage multiple investment types, consider working with an organization to manage your wealth for you. These professionals can help you report your income during tax season.
What Tax Breaks Are Lost Under AMT?
Tax breaks can lower your overall bill to the IRS. However, there are certain deductions that aren’t allowed with the AMT. These include state and local tax deductions, medical expenses (unless they exceed 7.5% of your gross income), and real estate property taxes. There are also restrictions on your home equity loan interest.
You can see how these deduction limitations can affect your overall portfolio. A real estate investment that would be considered profitable might not have the dividends you expect if you can’t count your property taxes and home equity loan interest as deductions. Similarly, other limitations on deductions (like incentive stock options) can also change your financial outlook.
Working with a trusted tax professional can help you make the most of your deductions so you don’t overpay your taxes. You should never feel blindsided by the AMT.