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Alternative Minimum Tax: 3 Things Every Taxpayer Must Know

By Dan Caplinger - Apr 12, 2016 at 12:40PM

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This little-understood tax snares millions of unsuspecting Americans.

Image source: via Flickr.

Most taxpayers have enough trouble getting through one set of tax laws to get their tax returns done. However, for millions of Americans, a completely different tax system plays a role in determining how much you have to pay Uncle Sam each year. If you don't know about the alternative minimum tax, then you could be in for a nasty surprise that can cost you thousands of extra dollars each year. Below, we'll look more closely at some key things you need to know about the AMT.

1. The AMT isn't just for the rich.
The alternative minimum tax in its current forms dates back to 1982, and it was originally set up to ensure that high-income taxpayers paid at least a minimum rate of tax. At the time, that was extremely important, because a combination of higher regular tax rates and more plentiful deductions made it possible for smart tax planners to slash or even eliminate their tax liability.

The exemptions from the AMT in the mid- and late 1980s were $30,000 for single filers and $40,000 for joint filers, which at the time prevented the AMT from actually being imposed on anyone who wasn't squarely in the high-income category. Those figures were only minimally adjusted until 2001, however, and so the impact of inflation gradually pushed more upper-middle income taxpayers into the AMT realm. In addition, as you'll see below, whether you'll get hit by the AMT depends a lot more on its specific rules than on your income level.

2. The AMT has its own set of rules.
The alternative minimum tax is a completely different parallel tax system, and the way it's set up, you'll end up paying tax based on whichever system ends up costing you more. If the AMT is higher, then you'll pay your regular taxes up to that amount, with the excess being AMT.

In particular, personal exemptions aren't recognized under the AMT, and you can't claim a deduction for state and local income or property taxes. Therefore, those taxpayers with large families who live in states with high taxes are most prone to be subject to the AMT. In addition, there's a long list of items on the 28-line Part 1 of the tax form governing the alternative minimum tax that you also have to account for differently, including everything from interest on private activity municipal bonds that are generally tax-free for regular tax purposes to income realized on the exercise of incentive stock options received as compensation. In essence, calculating the AMT is like doing your taxes a second time, and trying to coordinate the two can be extremely challenging.

3. The AMT doesn't hit as many people as it used to.
As onerous as the AMT is, it used to affect more people. The AMT exemption was set at $33,750 for singles and $45,000 for joint filers for years, and it took annual action by Congress to raise the limits up in order to index them to inflation. Without changes in the tax laws at the beginning of 2013 that made the indexing of the AMT exemption to inflation permanent, that annual exercise would still potentially be going on.

For those filing their 2015 returns, the exemption amounts are $53,600 for singles and $83,400 for joint filers. A tax rate of 26% applies up to $185,400 in income, with a 28% rate on income above that amount. Because those rates are less than the top ordinary income tax brackets, AMT now generally applies to a middle group of upper-middle to high-income taxpayers, with the ultra-rich typically paying more in ordinary taxes than they would under AMT.

Finally, keep in mind that AMT does incorporate some advantageous tax provisions. Most importantly for investors, the maximum rates on capital gains and qualified dividend income apply to the AMT as well as the regular tax. That means that even under the AMT, many ultra-rich individuals pay lower percentages of their income in tax than others who pay the AMT.

Many taxpayers never even think about the alternative minimum tax, but every year, it affects millions of tax returns. To avoid getting hit by the AMT, it's useful to know when it applies and how it differs from the regular tax system.

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