Alternative Minimum Tax: What Is It and Do You Need to Worry About It?

Source: 401kcalculator.org via Flickr.

There are two ways the IRS can calculate your federal income tax liability each year -- the standard method of using deductions, exemptions, and credits to determine your marginal tax rate or tax bracket, and a completely separate method called the alternative minimum tax, or AMT. More and more middle-class households are blindsided by the alternative minimum tax each year, so here's what you need to know about the tax and who it applies to.

What is the alternative minimum tax?
Basically, the alternative minimum tax is intended to ensure that high-income individuals can't use excessive deductions and exemptions to avoid paying their fair share of taxes. The tax has existed since 1969, and was originally aimed at top income earners who derived all of their income from tax-free bonds in order to avoid paying any taxes whatsoever.

At first, the tax made a lot of sense. It originally targeted people who earned over $200,000 per year, which was a massive income in 1969. Fast-forward 46 years, and the AMT thresholds now include many middle-income families.

Will you have to pay it?
Whether or not you'll have to pay alternative minimum tax depends on a few factors. Of course, the primary factor is your income. And, while it seems that earners in the $200,000 to $500,000 income level are most vulnerable, it's possible to get hit with an alternative minimum tax with an income greater than $83,400 for married couples and $53,600 for single taxpayers.

Other than income, the main determining factor is how many exemptions and deductions you have. For instance, if you have a bunch of kids, high medical expenses, and you have lots of miscellaneous itemized deductions, it's entirely possible to earn a six-figure salary and have zero federal income tax liability under the standard calculations.

However, your tax will be calculated using both methods -- the standard formula as well as the alternative minimum tax. If the alternative minimum tax is more than the standard calculated tax, you're responsible for paying the difference.

How is it calculated?
The calculation of alternative minimum tax is complicated (then again, what isn't complicated about the U.S. tax system?)

When calculating alternative minimum tax, a completely different set of exemptions and tax rates are used. The calculation starts with your regular taxable income, and then certain deductions are added back in. For wealthy taxpayers, deductions related to incentive stock options and tax-exempt interest from certain private activity bonds are added back, but there are many deductions commonly taken by middle-income taxpayers that are not allowed in the AMT calculation. Just to name a few examples of deductions that are not used when determining income for alternative minimum tax purposes:

• Deductions for state and local taxes you paid
• Miscellaneous itemized deductions -- this category includes deductions for unreimbursed employee expenses, tax preparation fees, and several other expenses.
• Property taxes
• Home equity loan interest, unless the loan funds were used exclusively for home improvements

Once the income subject to alternative minimum tax is calculated, an exemption amount is applied, which is $83,400 (married filing jointly) or $53,600 (single/head of household) for the 2015 tax year. The remaining amount is subject to tax rates of 26% or 28% depending on how much the income is, and if the income is high enough, the exemption amount begins to phase out. I know this sounds complicated, so here's a chart to help make sense of it.

If this still sounds complicated, don't worry. Few people actually calculate their AMT by hand. If you use a computer program to do your taxes, all of the major ones calculate the alternative minimum tax automatically. For the few people who prefer to do taxes by hand, the IRS provides an AMT assistant to help determine whether you should even fill out the AMT form.

Smart tips to reduce your alternative minimum tax
There may be a few ways to reduce the likelihood you'll get hit with the alternative minimum tax, or at least reduce the amount you'll have to pay. To get you started:

• Increasing your 401(k) contributions can help reduce your taxable income, and you can choose to defer $18,000 of your paychecks into your account in 2015 ($24,000 if you're over 50).
• Make sure your tax-free municipal bonds are AMT-exempt. Your financial advisor should be able to find this out quickly, and many bonds are actually advertised as "AMT free."
• Maximize your business tax deductions. If you file a schedule C, the deductions you claim are not affected by the alternative minimum tax calculations.

The bottom line
The alternative minimum tax has good intentions -- to make sure that loopholes don't allow the wealthy to avoid paying their fair share of federal income taxes. However, since the AMT thresholds are now in the realm of middle-class household incomes, it makes sense to familiarize yourself with the alternative minimum tax calculation process and whether it could affect you.