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How Alternative Minimum Tax Can Cost You Thousands at Tax Time

By Dan Caplinger - Mar 16, 2017 at 7:22AM

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The alternative minimum tax can come as a shock to taxpayers who don't know about it.

Nobody likes to pay more tax than they have to, and the burden of putting together your tax return challenges millions of Americans. Yet the alternative minimum tax can force you to do a second set of numbers for your return and lead to a tax bump of thousands of dollars. In order to prepare for and potentially avoid the AMT, it's essential to understand how it works and how it differs from the regular taxes you'll owe.

Why is there an alternative minimum tax?

The current version of the AMT was created in 1982, with the goal of making sure that high-income taxpayers who took advantage of many different tax breaks would nevertheless pay some minimum amount of income tax. Higher regular tax rates and broad-based deductions made it easier for wealthy taxpayers to find breaks to cut their taxes, and the AMT limited some taxpayers' availability to take advantage of those provisions.

Yet more recently, the AMT has affected an increasing number of taxpayers. That's because until recently, the income limits at which the AMT kicks in weren't adjusted for inflation. As wages grew steadily over time, the alternative minimum tax became less tailored toward the wealthiest taxpayers and began to include some whom one might include among the upper middle class. That means that even those of more modest means have to be aware of how the AMT can affect them.

Keyboard with blue tax key.

Image source: Getty Images.

What rules does the AMT follow?

The most confusing aspect of the alternative minimum tax is that it has its own set of rules. In some cases, deductions that are available for regular income tax aren't available for AMT or vice versa. But the IRS sets things up in its favor, so whichever tax system produces the higher bill is the one that you have to pay.

The most important difference between the AMT and the regular tax system for most taxpayers is that itemized deductions for state and local tax payments aren't available under the AMT, and the personal exemptions that people get for themselves and their dependent family members also don't show up as deductions for AMT purposes. If you live in a state with high taxes or if you have a large family, then you're more likely to get snagged by the AMT. Yet the smaller differences between the two tax systems abound, with more than two dozen provisions inviting different treatment between the AMT and regular income tax.

Will someone fix the AMT?

Believe it or not, the AMT used to be worse than it currently is. For years, lawmakers made one-year extensions of provisions that boosted the exemption amounts under the alternative minimum tax. Without those moves, AMT would have hit far more people, because with exemptions of just $33,750 for singles and $45,000 for joint filers, many middle-class families would have faced alternative minimum tax liability.

However, in 2013, lawmakers made inflation-indexing permanent, and that helped immensely. For 2016 tax returns, exemptions of $53,900 for singles and $83,800 for joint filers apply. After that, a 26% rate applies up to $186,300 in income, with the rate going up to 28% above that level. Lower rates apply to dividend and long-term capital gains income.

Moreover, some have called for even sharper moves to reform the AMT. President Trump's tax plan includes repealing the alternative minimum tax, replacing it with his structure of fewer tax brackets. The move would prevent anyone from having to consider how the AMT might impose additional tax, although opponents note that the benefit of getting rid of the AMT would favor the wealthier taxpayers who are most often faced with paying it.

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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