Written by: Ric Edelman, Acclaimed Financial Advisor
If you haven’t been affected by the Alternative Minimum Tax, chances are you soon will. Originally an arcane section of the tax code designed to prevent rich people from avoiding taxes, the AMT is increasingly ensnaring middle class taxpayers. The result: You can expect your taxes to rise, even though Congress keeps cutting tax rates and offering new tax deductions and tax credits.
It’s not the first time this has happened. In fact, it’s how our nation’s tax system was born. In 1913, Congress passed, and the states quickly ratified, the 16th Amendment to the Constitution, which gave Congress the power to tax income. The law was popular because that first tax code levied a mere 1% tax on income — and only on those whose incomes exceeded $20,000. (That’s the equivalent of earning $365,000 in 2004 dollars.)
But we know what’s happened in the years since. Today, adults with incomes as low as $8,000 are subject to federal income taxes, and the top tax rate has skyrocketed to 35%.
The AMT story is similar. When it became law in 1970, fewer than 19,000 Americans paid it. But by the end of this decade, the Congressional Budget Office estimates that more than 35 million taxpayers will pay the AMT — that’s one-third of all U.S. taxpayers (probably including you). If Congress doesn’t do something, nearly everyone who pays taxes will pay the AMT by 2020 (almost certainly including you). But don’t expect Congress to fix this. That’s because the AMT will generate more than $15 billion in revenue this year; by 2010, it’s expected to collect $130 billion, accounting for five cents of every dollar that pours into the Treasury’s coffers. So it’s time for you to learn about the AMT. It’s really quite simple. The U.S Congress has created two sets of tax rules; you must compute your taxes both ways and (naturally) pay the higher amount. That’s all there is to it.
Congress created the second — ALTERNATIVE — tax code to thwart rich Americans who were taking advantage of all those loopholes, dodges, and avoidance schemes you keep hearing about. You know the stories — guys who make millions but pay nothing in taxes, thanks to their clever use of deductions, exemptions, exclusions, and credits. To stop them, Congress made rich folks compute their taxes a second time — but this time, they don’t get to claim all those deductions that enabled them to wipe out their tax liability the first time around. As a result, rich Americans were forced to pay at least something — a MINIMUM — which is much more than they otherwise would have paid in TAXES. So far so good.
Nobody (except maybe the rich folks themselves) would complain about this, and indeed no one (except maybe the rich folks themselves) did complain. But when Congress wrote the AMT rules, they forgot (on purpose????) to index the AMT for inflation. You see, the original rules said that the only people who had to recalculate their taxes using the AMT rules were those who earned more than $30,000.
But today, $30,000 is nothing more than a lower middle class income, and as a result, millions of Americans owe the AMT. And it’s going to be even worse next year: in 2006, married filers who earn more than $49,000 and singles/heads of households earning more than $35,750 will fall into the AMT net.How does the AMT cause you to pay more in taxes? It denies or reduces tax deductions for such items as personal exemptions, state and local income taxes, itemized medical expenses, interest on a second mortgage (unless used to improve the house), miscellaneous itemized deductions, and capital gains (although there are some exemptions). And, the more you spend on any of these items, the more the AMT will cost you. Is there a silver lining?
Sort of, thanks to something often called the minimum tax credit. To be eligible you must have previously paid the AMT, but not owe the AMT in the year you plan to claim the credit. Here’s an example:Say that last year when computing your taxes using the traditional method, you owed $30,000. Then, when you re-did your taxes using the AMT method, your tax bill rose to $35,000. (In IRS jargon, your AMT bill was $5,000.) Let’s further say that this year, using the traditional method, you owe $51,000; however, the AMT version requires only $44,000. You are eligible to reduce your taxes this year by the $5,000 you paid in AMT taxes last year.
As a result, your actual federal income tax liability this year is $46,000. Are you getting all this?
So what should you do? Compute your income tax liability both ways. Since Form 6251 — the AMT form — is nasty, so I recommend you hire a tax professional, such as an Enrolled Agent, CPA, or tax attorney to do it for you. If you insist on using tax software, make sure it will compute your AMT for you. And if you really are a glutton for punishment, go to www.irs.gov and download IRS Form 6251 and the associated instructions and try to fill it out yourself.
Oh, by the way, you might lose the ability to claim some or all of your tax credits even if you don’t owe the AMT. How can this happen? Say that, before you claim any tax credits, you determine that you owe more under the traditional tax system than under the AMT. Further say that after you claim the credits, you find that your tax under the AMT is higher than the traditional method.
Since you can’t pay less than the AMT (recall what the M stands for), you could lose the ability to claim the credits even though you’re not technically filing under the AMT. That’s why you will probably have to file Form 6251 even if you don’t owe the AMT but are merely potentially affected by the AMT.Are you hating this yet? You will. Because even if you don’t yet owe the AMT, well, you will.
