Sooner or later, the alternative minimum tax (AMT) is probably going to get you.
Strategy: Do your best to dodge this “stealth tax.” At the very least, you may be able to reduce your AMT liability for 2012 with some advance planning.
5 steps for figuring the tax
First, let’s briefly explain how the AMT works. In essence, you’re required to run parallel calculations of your regular income tax liability and AMT liability. Then you must effectively pay the higher of the two.
There are five steps for computing AMT liability:
1. Figure out your taxable income for regular tax purposes.
2. Add designated “tax preference” and “adjustment” items to this figure (see box below).
3. Subtract a special exemption amount based on your filing status. This is one of the areas where Congress has patched the law in recent years.
4. Apply the AMT rate to the net amount. The AMT rate is 26% for the first $175,000 of AMT income; 28% for AMT income above the $175,000 level.
5. Compare the AMT result to your regular income tax and pay the higher tax liability.
But here’s the kicker: The exemption amounts (Step 3) are reduced for high-income taxpayers. The reduction is equal to 25 cents of each dollar of AMT income above $150,000 for joint filers; $112,500 for single filers. Unlike the exemption amounts, Congress has not adjusted these dollar thresholds.
Once AMT income exceeds $382,000 on a joint return, or $273,500 for single filers, you get no exemption at all.
4 ways to sidestep the AMT
If you’re in the “danger zone,” there are several ways you might skirt the tax.
1. Delay capital gains. If you expect to realize a large capital gain, postpone the sale until next year or arrange an installment sale to spread out the tax over time.
2. Time income tax payments. Don’t prepay state and local income and property taxes. While deductions for these prepaid amounts will cut your regular taxable income, they are added back to your AMT income calculation. Instead, prepay just enough to bring down your regular tax liability to equal the amount of your AMT liability.
3. Avoid “private activity” bonds. Generally, the income generated by most municipal bonds and muni bond funds is exempt from both regular income tax and the AMT. But if bonds are used to finance private activities—such as housing projects, hospitals or certain industrial parks—the income may be subject to the AMT.
Tip: The offering prospectus for potential investments will tell you if it’s free from the AMT.
4. Put ISOs on hold. If you exercise tax-favored incentive stock options (ISOs), the “bargain element” (the difference between the option price and fair market value of the stock when you exercise) is treated as a preference item for AMT purposes. By spreading out ISO exercises over several years, you may be able to avoid an AMT hit.
Tip: If you want to exercise ISOs this year, you might arrange to sell the shares in 2012. There is no AMT hit on shares that are bought and sold in the same year.
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