Understanding the Alternative Minimum Tax (AMT)
Each year, more and more physicians find themselves subject to the Alternative Minimum Tax (AMT). When asked, many don’t know how they got there or what, if anything, they can do about it.
The first year I owed AMT tax caught me by surprise. I’d run through tax projections with my accountant at quarterly intervals throughout the year. Why were our projections off by more than $10,000? Why are many physicians paying between $5,000 and $15,000 per year in taxes that they do not owe under our normal tax system? Enter the AMT.
This brief post will educate you on the AMT, some common triggering pitfalls for physicians, and finally, what might be done to minimize its impact on your taxes.
What is the AMT?
The alternative minimum tax was instituted back in 1969 when 155 American families earning more than $1 million dollars owed $0 in federal income tax. This was due to the way deductions were established at the time. Congress didn’t think these families were paying their fair share. Instead of changing the tax code for everyone, they decided to institute an entirely new tax structure to bring these families back into the tax-paying fold.
In its most basic form, the AMT is a totally separate way of calculating how much you owe in taxes. By examining line 45 of your personal tax return (2011 Form 1040), you’ll quickly see if you have been historically falling under this other tax structure. To simplify, think of AMT as a flat tax rate of approximately 28%. This is different than the effective and marginal tax rates you’ve already learned about. Under AMT, there are only two marginal brackets—a 26% bracket and a 28% bracket. The 28% bracket kicks in after $175,000 of income.
What causes you to be subject to AMT?
You’re subject to the AMT because you are eligible for deductions under our normal tax system that Congress has deemed inappropriate for the AMT system. Some deductions are safe under AMT, and don’t hurt you, while other deductions are not and can. Because of this, it’s not easy to look at someone’s income and know in advance if they will or will not be subject to AMT. A general rule of thumb is that you are more likely to be subject to AMT if your income is between $250,000 and $500,000 per year, but several families with incomes in excess of $1 million per year still owe AMT.
Following are two lists. First, the deductions normally considered safe under AMT. Second, a list of the deductions or other tax advantages that can often trigger AMT tax to be owed.
What deductions are typically safe under the AMT?
- Charitable contributions
- Mortgage interest for your personal residence (note the home equity loan exception below)
- Deductions for your business taken on Schedule C or through your LLC or S-Corp
- Retirement plan contributions
What deductions or tax-advantaged issues can commonly cause a physician to be subject to the AMT?
- Property taxes
- State and local taxes
- Mortgage interest for certain home equity loans
- Unreimbursed business expenses deducted on Schedule A
- Professional fees deducted on Schedule A (including legal and investment advisory fees)
- Realization of long-term capital gains
- Interest from certain municipal bonds deemed “private activity bonds”
- The exercise of incentive stock options (provided by an employer)
- Use of the standard deduction
What are some ways to potentially reduce exposure to the AMT?
- Claim itemized deductions even if smaller than the standard deduction.
- Ask for a larger expense reimbursement account from your employer in exchange for a smaller salary.
- Increase contributions to retirement plans offered by your employer.
- Use a dependent care reimbursement arrangement through your employer to deduct your childcare expenses rather than claiming these deductions on your tax return.
- Consider timing state, local, and property tax payments to bundle them into an every-other-year payment structure.
- Reduce exposure to private activity municipal bonds.
- Have your investment advisor bill fees to your IRAs or 401(k) rather than your taxable (non-qualified) account. (if you fall under AMT, then you are not able to deduct investment advisory or other professional fees even if they exceed the 2% threshold)
- Consider converting traditional IRA funds to Roth IRA funds if you are comfortable with a 28% tax rate.
Each situation is unique. Even if you find you owe AMT, there may be ways to reduce or eliminate it. We advocate that physicians should have their accountant run a year-end tax projection each November. This way they can see if AMT is an issue and seek to reduce exposure if possible.
This information is provided for educational purposes only and should not be considered tax advice. Each individual’s tax situation is unique and you should consult your tax adviser prior to taking any action.
Advisory services are offered through Larson Financial Group, LLC a Registered Investment Advisor.