Congress is hard at work right now revising the tax code, a process that has added a great deal of uncertainty to year-end tax planning. I’ve heard from a number of people who are worried about losing deductions next year, and even some who are considering prepaying currently deductible expenses like property and state income taxes. However I would like to caution you against taking drastic steps. We don’t have, and may never have, a final bill. As such, we don’t know what specific provisions will remain or how the lack of provisions will affect your overall situation.
Your taxes, as well as the rest of your financial life, are like a set of dominoes. Changing one piece almost inevitably affects others. This is especially true when it comes to the Alternative Minimum Tax (AMT), which the House has removed from its plan but the Senate has retained (although with a higher exemption amount).
Today I want to cover AMT and how it works now. I’ll also discuss how this tax can interact with other provisions – because AMT may make prepaying deductible expenses now a costly mistake.
What is AMT?
As the name implies, AMT imposes a minimum tax on the amount of your taxable income above a designated exemption. The tax was introduced to make sure people with higher incomes pay a minimum amount of tax. Otherwise they might escape income tax entirely by taking advantage of deductions and credits. AMT parallels the regular income tax system. To find out whether you owe AMT, you have to calculate both your income tax and your AMT and pay the higher total.
For income tax purposes, you calculate your taxable income based on your gross income minus adjustments, your standard or itemized deductions and your personal exemptions. The government taxes that figure at a progressive tax rate, that is, the more you earn the higher a rate you pay, to determine the total amount of tax that you owe (which you can later reduce through tax credits).
You also calculate AMT based on taxable income. However, under AMT, certain deductions are diminished or disallowed entirely. Some of these deductions include personal exemptions, state and local income taxes, miscellaneous itemized deductions and mortgage interest on home equity debt. Accordingly, you’re most likely affected by AMT if you have a large family, high state income and property taxes, and/or high miscellaneous itemized deductions like investment management expenses.
You may also have to include certain types of income that you wouldn’t normally count in your regular taxable income, such as exercising incentive stock options or tax-exempt interest from private activity bonds.
The disallowance of deductions and addition of income leads to your Alternative Minimum Taxable Income (AMTI).
When trying to understand the basics of AMT, it’s more important to know how the calculation works, rather than knowing every deduction or type of income that gets added back in to your AMTI. Your preparation software will calculate AMTI for you and show you the different aspects that affect your particular situation. However, if you’re really into figuring out the nuts and bolts of the AMTI, I will provide some resources below that will take you more in depth.
Exemption Amounts – The Second Part of Your Equation
Once you’ve figured out your AMTI, you’re 80% of the way there. The next step involves calculating the amount of income subject to tax. To do that, you need to subtract the exemption amount from your AMTI.
The exemption amounts are preset and indexed for inflation. For 2017, you can exempt the following amounts of income:
- $54,300 for single and head of household filers (which begins to phase out 25 cents for every dollar above $120,700),
- $84,500 for married people filing jointly and for qualifying widows or widowers (begins phase out at $160,900), and
- $42,250 for married people filing separately (starts phase out at $80,450).
In short, your AMTI minus your exemption equals the amount of income on which you have to pay AMT. And as you can see higher income individuals may lose their exemption amount entirely.
AMT Tax Rates
Despite the complexity of the AMT system, the tax rates are pretty straightforward.
For 2017, you pay a tax rate of 26% on AMTI of $187,800 or less for those filing single, married filing jointly, head of household or qualify widower. For married filing separate taxpayers, the income threshold stops at $93,900. The tax rate grows to 28% of income over those amounts. Multiplying your AMTI minus your exemption times the corresponding tax rate gives you your tentative minimum tax.
You may have some additional tax due if you reported capital gains distributions, qualified dividends, and/or used the foreign tax credit, but your software should add those for you.
You should note that AMT is only the difference between your regular income tax and the tentative minimum tax amount calculated through AMT. For example, if you owed $30,000 in regular income tax and your tentative minimum tax amount was $33,000, AMT of $3000 will show up on line 45 of your Form 1040.
Do Your Research
AMT intimidates a lot of people, even many tax professionals. But you can find some helpful resources to guide you through the process of calculating AMT. As always, I start with the form itself – Form 6251 – and its instructions. The IRS also offers an AMT Assistant that helps you determine whether you might be subject to AMT.
We don’t know what will happen with AMT in 2018, but it will definitely be in force for 2017. As a result, higher income tax payers near the exemption phase out should be careful about accelerating deductions for mortgage interest and state and local taxes, since these are not allowed under AMT. Prepaying them now could mean the loss of deduction due to AMT this year and the loss of the deduction next year since the taxes are already paid. If you find yourself subject to AMT and need to develop strategies for minimizing the minimum tax, I suggest seeking a tax professional who knows the complexities of the system.
Lastly, I would like to add that just because you can’t anticipate the tax law changes on the horizon, that doesn’t mean you shouldn’t do end of the year planning at all. I’ll cover some tips for that next week.