Alternative Minimum Tax (AMT) is Not a Bonus Penalty Tax

Have you heard someone who has to pay AMT for the first time talk about AMT?    They act as if they're being punished with a penalty tax.   "Oh no, I made too much and now I have to pay AMT!" is how the complaint usually sounds.   AMT is not really an extra tax paid as a penalty simply because you made a lot of money.   We already have tax brackets setup that cause higher taxes for higher income.  AMT is not a extra tax either in the sense that they don't simply say "oh you made too much money so you have to pay $1000 more" as some people seem think.   It is an alternative way to calculate taxes to set a minimum tax, hence the name.   What in effect AMT does is basically disallow some deductions and credits then figure a different tax calculation of basically 26-29% tax rate after a large exemption.

First lets go back and review some basic info on AMT that I've written before.  In an old article from 2008  What is the Alternative Minimum Tax (AMT) and how does it work?  I gave a basic discussion of the tax.  That article is now a bit dated since the numbers have changed but the basic idea is the same.  Who Pays the Alternative Minimum Tax (AMT)? I discussed how only around 2-3% of people pay it and almost all of them have AGI over $200k.

The key word in Alternative Minimum Tax is MINIMUM.   Its not the Maximum tax.    Its a minimum tax rate.      The AMT tax rate is LOWER than the standard tax rate with standard deductions.

Here's how it works.   First you figure your taxes normally.   You take your income then subtract any kind of deduction you can claim and calculate your income tax rate based on the progressive tax brackets.  Then you subtract credits you're eligible for.    Thats the normal tax calculations.  But way back people realized that high income folks were finding all sorts of tax loopholes to avoid taxes and ending up paying little in tax.  So they implemented the AMT which simply takes your income, subtracts a large exemption then figures a tax % of the rest.   Then you pay the tax which is higher.   If your normal tax figures are higher than the AMT then you don't pay AMT.  

Lets look at some examples :
I'll use TaxCaster to estimate taxes.   I'll take an example of a single person living in Texas where there is no state income tax.   Lets say you make $200,000 from your job and you own a house.   Your house is pricey and you have a $25,000 interest bill.    For arguments sake lets say that since you just bought the house this year there is no property taxes due this year but you'll have to pay double property taxes next year.       Your tax situation is simply $200k of income and $25k of deductible mortgage interest.   You would owe a tax bill of $41,201 for that year.   OK.  Then the next year you've got that property tax bill due. So in the next year you've got a $25,000 property tax bill (double the normal).   That gives you $200,000 of income plus $50,000 of deductions ($25k mortgage interest + $25k property tax).   Your taxable income is only $150,000 and your regular tax rate works out to $34,201.      BUT here comes AMT.    When you figure the AMT you don't get that property tax and your AMT rate adds another $1,679 to your tax rate for a total tax bill of $35,880.

Situation A :   $200k income, $25k mortgage interest = $41,201 regular tax bill, NO AMT
Situation B: $200k income, $25k mortgage interest, $25k property tax = $35,880 tax bill including $1679 of AMT

Situation B has a lower tax bill and pays AMT.   Would you prefer to pay $41,201 in taxes or $35,880 in taxes?    Thats an easy one.   Clearly $35,880 is cheaper.   Yet the $35,880 tax bill includes AMT?    This tax payer in situation B is "Hit with AMT" yet has a lower tax bill than in situation A.

Now lets say a few years later you are promoted to VP and your income has more than doubled and you now make a whopping $500,000 a year.  You're still paying that $25,000 mortgage interest and again hit with the $25,000 property taxes.   In this situation you would have $500k income and $50k deduction.  Your regular tax bill would be $138,934.   However you would NOT owe any AMT even though $25k of your deductions from property tax is disallowed in the AMT calculation.

Situation A : $200k income = $41,201 tax bill, NO AMT= 20.6% effective tax
Situation B : $200k income = $35,880 tax bill & AMT of $1679 = 17.9% effective
Situation C : $500k income = $138,934, NO AMT = 27.8% effective

Again, lets play dumb and choose between A,B, & C and decide if we want the one with AMT or not.   Situation B has the lowest effective tax rate, and the lowest total tax bill yet they are still paying an AMT. 

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