Despite the recent talk in Congress about alternative minimum tax (AMT) reform (see page 3), the "stealth tax" is still expected to hit millions of unsuspecting taxpayers this year ... maybe even you.
Strategy: Take matters into your own hands. Quickly estimate your potential AMT liability for 2005 using our work sheet on page 2. It will show if you need to "push" or "pull" at the end of the year.
How the AMT works
Each year, you're required to run parallel calculations showing your regular income tax liability and your AMT liability. Then, you pay the higher tax.
Computing AMT liability involves five basic steps:
1. Figure your taxable income for regular tax purposes.
2. Add designated "tax preference items" to this figure and make other technical adjustments, such as the addition of personal exemptions and some itemized deductions.
3. Subtract a special AMT exemption amount based on your filing status. (The exemption is reduced for high-income taxpayers. The reduction is 25 cents for each dollar of AMT income above $150,000 for joint filers; $112,500 for single filers.)
4. Apply the AMT tax rate to your net income. The AMT rate is 26 percent for the first $175,000 of AMT income; 28 percent for AMT income above $175,000.
5. Compare the AMT result to your regular income tax owed. Then, pay the higher of the two.
Who does the AMT affect? It most often hits taxpayers in high income-tax states who lose the benefit of state for AMT purposes. That's also true for taxpayers with numerous personal exemptions.
Another problem: The AMT exemption amount hasn't kept pace with inflation over the years. Net result: If left unchanged, the AMT will penalize nearly 20 percent of taxpayers by 2010, up from 3 percent this year.
4 ways to skirt the AMT
If your estimate indicates a potential AMT liability for 2005, here are four ways to help you sidestep the tax:
1. Time your state and local tax payments. Don't prepay state and local income or property taxes to reduce your regular income tax bill. State and local tax payments are added back when calculating your AMT income.
Instead, prepay only enough to bring down your regular tax liability to the amount of your AMT liability. Tip: Talk to your tax pro about striking the proper balance.
2. Delay capital gains. If you expect to realize a large capital gain—say, from the sale of real estate or securities—it could significantly reduce your AMT exemption amount. Postpone the sale until next year or arrange an installment sale to spread out the gain over several years.
3. Avoid private activity bonds. Interest 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: Check out the offering prospectus for a potential investment; it will tell you if it's free from the AMT.
4. Put some ISOs on hold. If you take advantage of tax-favored incentive stock options (ISOs), the "bargain element" (the difference between the option price and fair market value of the stock on the exercise date) is treated as income for AMT purposes.
By postponing exercising some options, you can spread out the potential liability over several years.
Last resort: If you can't avoid the AMT in 2005, embrace it. Accelerate income into this year that will be taxed at the AMT rate if it's lower than your regular tax rate. Example: If you're normally in the 33 percent tax bracket and the extra income will be taxed at the AMT rate of only 26 percent or 28 percent, that's a tax savings you might want to grab now.
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