November 19, 2008

What is the Alternative Minimum Tax (AMT) and how does it work?

[edit : Note that this article is out of date now and the details such as exemption figures have changed over time ] 

You may have heard of how the AMT or Alternative Minimum Tax is starting to impact more Americans. AMT doesn't impact too many Americans. In 2005 about 3% of tax filers ended up paying AMT. But one ongoing issue with AMT is that its exemption rates are not indexed with inflation so if the exemption isn't increased then it will impact more people every year. Thankfully congress has been passing increases to the exemption to increase the thresholds. SO in the future it may become more relevant and as your income goes up it is something to be aware of.

Why was it created?

From the Congressional Budget Office: "The stated purpose of the alternative minimum tax (AMT) is to keep taxpayers with high incomes from paying little or no income tax by taking advantage of various preferences in the tax code. The AMT does so by requiring people to recalculate their taxes under alternative rules that include certain forms of income exempt from regular tax and that do not allow specific exemptions, deductions, and other preferences"

So basically as AMT name indicates it is an alternative to the normal taxes that incurs a minimum tax level.

So should you worry?

When AMT won't impact you:

If your adjusted gross income is less than the exemptions ($46,200 for single or $69,950 for married in 2008) then you will NOT be impacted by AMT.

If you do not itemize or have any credits then you are unlikely to be impacted by AMT.

When AMT might impact you:

You're more likely to be impacted by AMT with higher income.

If you have a high income with lot of credits and deductions then its more likely to be paying AMT.

How do you figure if you're impacted?

There is no specific income threshold or straight forward rule about who is or isn't going to pay AMT. Its actually a bit complex to figure and that's one of the criticisms of AMT. Thankfully the IRS has provided a relatively easy way to figure if AMT might impact you by using the IRS AMT assistant. Its a simple web wizard that asks you a few questions and will tell you if you would have to figure AMT or not. They don't have one up yet for 2008 but you can see the 2007 version for reference. But keep in mind that they raised the exemption levels for 2008 so the 2007 numbers are a little bit different.

What you are supposed to do is fill out a worksheet in the tax form instructions to determine if you might owe AMT. The worksheet might tell you if you do not need to worry about AMT. Or it might tell you that you have to figure AMT. To figure the AMT fully you use the IRS form 6251. If you do have to figure AMT then you figure the AMT tax and the regular tax and then you pay the larger of the two.

A method to approximate AMT

First a note, this method is just a very rough approximation and if you are filing taxes then you should really use the full worksheets and ideally seek the aid of a Certified Public Accountant. I only present this method as a very rough aid to figure if you're in the ballpark for AMT or not. At a very basic level AMT is calculated by taking your Adjusted Gross Income (AGI) minus exemption and multiplying by 26-28%. The exemption for 2008 is $46,200 for single and $69,950 for married filing jointly. Also if your income is over $112,500 for single or $150,000 for married joint filers then they start to phase out that exemption. Usually the AMT tax is 26% but it hits 28% for higher incomes. So that would give us approximations of the following:

For filers with income of less than $112,500 for single or $150,000 for married:

AMT tax = (Adjusted Gross Income - exemption ) X 26%

Where exemption is $46,200 for single and $69,950 for married. Keep in mind that this is just a rough calculation.

For example: if you are married and you made $120,000 income then it would be :

(120000 - 69950) * .26 = $13,013

By comparison if you took a standard deduction and 2 exemptions then your tax for $120,000 for a married couple with no children would have been $18,473 in 2007. So the AMT tax rate is $5,460 less than the standard tax. So in this example you would have to pay the regular tax rate and AMT is less so it would not impact you.

If your income is over $112,500 for single or $150,000 for married then you will start to lose some of the exemption. You have to add back 25% of the difference between your income and the threshold.

SO if you make over the thresholds of $112,500 for single or $150,000 for married then that would make it :

AMT tax = ( (AGI - exemption ) + ( (AGI - threshold ) x 25% ) ) x 26%
For example, lets say you're married couple making $200,000. That would give:
(( 200000 - 69950) + (( 200000 - 150000) * .25) ) * .26 =
( 130050 + (50000 * .25) ) * .26 =
(130050 + 12500) * .26 =
142550 * .26 = 37063
AMT Tax = $37,063

By comparison the tax rate with a standard deduction and 2 exemptions from 2007 would have been $45,200.

If your income exceeds a certain level then you'll have to pay 28% on the top margin as opposed to 26%. This rate doesn't hit until you're making over $250,000 or so. I'm not going to go into that level of detail here as this is just an approximation. If you make $250,000 then you should probably work with a CPA.

So, in summary:

  1. AMT was established initially to make sure certain high income individuals wouldn't be able to avoid all tax liability.
  2. The AMT might impact you if your income is relatively high.
  3. I'd use the AMT Assistant on the IRS site to determine if you have to fill out the IRS form 6251.
  4. You can use the formulas above as a ballpark estimate for the AMT tax rates but this is just a rough estimate.
  5. To calculate your actual AMT tax amount you would need to use the complete 6251 form.

One last note: I'm not a tax professional and the information presented here is not meant as tax advice. You should seek the advice of a qualified tax professional when you file your taxes.

Additional resources on AMT:

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