Of course, higher taxes are a major concern for upper-income taxpayers in 2013. The top tax rate increases from 35% to 39.6% on ordinary income, while the maximum rate for capital gains and qualified dividends soars from 15% to 20%. But that isn’t the only tax obstacle in your path this year.
Strategy: Don’t forget about the Alternative Minimum Tax (AMT). Although slight modifications to the AMT in 2013 may help, this “stealth tax” will still blindside millions of taxpayers.
Use 4 steps to compute the AMT
The AMT operates as a parallel tax system. After you’ve figured out your regular taxable income at tax return time, you must compute the AMT. There are four basic steps.
- Add certain “tax preference items” to your taxable income and make other technical adjustments required by law.
- Subtract from this figure an exemption amount based on your filing status (unfortunately, the exemption phases out at higher income levels).
- Apply the AMT rate to the net amount. The applicable rate is 26% on the first $175,000 of AMT income; 28% on amounts above $175,000.
- Compare your AMT liability to your regular tax liability. If the AMT is higher, you are required to pay the excess in addition to your regular tax liability.
There’s a laundry list of preferences and technical adjustments. Significantly, you must add back certain itemized deductions (most important the deductions for state and local income and property taxes) and all personal and dependent exemption deductions.
The American Taxpayer Relief Act (ATRA) permanently boosts AMT exemption amounts (see below) and allows nonrefundable personal credits to offset AMT liability in full. But, for many taxpayers, the AMT changes are too little, too late.
Use 4 ways to sidestep the AMT
Here are four possible ways you might reduce or eliminate AMT liability.
- Put some ISOs on hold. If you own incentive stock options (ISOs) permitting you to buy company stock at a stated exercise price, the “bargain element” (i.e., the difference between the option price and fair market value of the stock at the time of exercise) is considered a tax preference item. Spread out the tax hit by staggering the exercise of ISOs in different tax years.
- Time state tax payments. A common tax-planning move is to prepay state and local income and property taxes at year-end to boost deductions. But you have to add back these payments for AMT purposes. Pay out just enough to bring down your regular income tax liability to the level of your AMT liability.
- Avoid certain muni bonds. Generally, income from municipal bonds (“munis”) is exempt from federal income tax. However, if you invest in “private activity bonds” (e.g., munis used to finance an industrial park), the tax-free interest increases AMT liability. Consider this aspect in your muni bond portfolio decisions.
- Postpone capital gains. When it otherwise makes sense, you might delay selling securities or other property that will result in a large net capital gain for the year. That way, you might be able to avoid having your valuable AMT exemption partially or totally phased out because this year’s income level is too high. Remember that large capital gains may also trigger or increase the 3.8% Medicare surtax on investment income.
Tip: Depending on your status, you might shift items of income or deduction at year-end to your tax advantage. Note that additional AMT income is taxed at a rate no higher than 28%.
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