How can capital gains affect AMT?

When your adjusted gross income falls roughly in between the $100,000 to $400,000 range, alternative minimum tax may rear its ugly head. Below that and likely you aren’t going to be making enough to trip the AMT rules. Above that, enough of your income will be taxed at higher rates that AMT won’t apply.

A number of things can trigger having to pay AMT, all of which are typically caused by deductions that would normally put your regular income at a lower tax rate than the 26%-28%* rate you would have to pay on the same regular income under AMT.

Classic examples are your personal exemption and itemized deductions, especially if you live in a high-tax state such as New York or California. However, a long-term capital gain can also trigger having to pay AMT, even though you still end up paying 15% on the long-term capital gain itself.

This little bit of nefariousness is due to how the AMT rules are constructed.

When figuring out your AMT income on the AMT worksheet, your capital gains are included in your total income. Your exemptions and most of your deductions are then added back to your adjusted gross income and you instead subtract the AMT exemption.

However, if your income falls above a certain point (and remember that income includes your capital gains and dividends), that exemption starts to reduce by 25 cents on the dollar for any amount over the income cap.

Some AMT math

For example, in 2014 the AMT exemption phaseout started at $117,300 and the exemption was $52,800 for people filing singly. If you made $120,000 in regular income and had a $75,000 long-term cap gain, that $52,800 exemption would get reduced by ($2,700 + $75,000) *.25, or by $19,425. That would push $19,245 of your regular income into the 26%-28% AMT bracket, raising your total tax bill.

For people making in the neighborhood of $400,000 or more, enough of their regular income is already taxed at rates higher than the AMT rate of 26%-28% so there’s rarely any need to pay AMT.

For those people stuck in between roughly $100,000 to $400,000 though, enough of your regular income percentage-wise is still in the bottom tax brackets of 10%, 15%, and 25% that the AMT tax is likely going to be higher than your regular income tax.

Playing around with Money Chimp’s tax calculator for example, someone with $100k in regular income would pay a 21.2% tax rate while being in the 28% tax bracket, and someone making $400k in regular income would pay a 29% tax rate and be in the 33% tax bracket.

AMT in the latter years

Those people no longer pulling in substantial regular income don’t generally need to worry about AMT either, since there is no regular income to tax at the high rates. Although it wasn’t the law’s original intent, AMT can now affect upper-middle-class working folks who have been diligent investors.

So there you have it. No need to be surprised any more during tax season by a several-thousand-dollar tax bill to the IRS due to AMT caused by long-term capital gains.

*In case AMT couldn’t get any more complex, there are two AMT rates: 26% and 28%. You pay the higher rate when your income is over a certain threshold. In 2014 that threshold was $182,500 for people filing singly.

— Answer provided by Motley Fool member Michael Sandrik