Like a Sudoku puzzle, the Alternative Minimum Tax is a matrix of different variables that can be hard to get your head around. The fact that the AMT depends on so many different factors makes it difficult to determine whether you're likely to be vulnerable to this often-onerous tax, let alone figure out what steps you could take to reduce your exposure to it.
To shed some light on the situation, it helps to remember that the factors that put you at risk for paying AMT fall into one of two buckets. The first factors are those that increase the income that's subject to AMT. The second group has to do with deductions, exclusions, and credits that you can take on your regular tax form but that aren't allowable under the AMT system.
In this week's column, I'll discuss how you can exercise control over some of these factors. You may not be able to eliminate your AMT exposure entirely, but you may be able to reduce the amount of AMT you owe or ensure that you don't fall into the "AMT zone" in any more years than you have to.
Ways to Control Income
Be Choosey about Munis
Income from municipal bonds isn't subject to federal income tax under the regular tax system, but income from certain munis is subject to the AMT. Thus, if there's a risk that you'll fall into the AMT zone, you'll want to avoid private-activity bonds (and municipal-bond funds that might buy them) like the plague. That doesn't mean you should run out and buy a taxable-bond fund, however, as that will only increase your taxable income (which, in turn, will put you at higher risk for having to pay the AMT). Instead, seek out muni funds with the words "tax-free" or "tax-exempt" in their names. Such funds are required by law to invest 80% of their assets in bonds that aren't subject to any tax, including the AMT. My favorites include Fidelity Tax-Free Bond (FTABX) and Vanguard Intermediate-Term Tax-Exempt (VWITX).
Handle Options with Care
As is the case with income from private-activity bonds, incentive stock options are treated differently under the AMT system than they are under the regular tax system. I firmly believe that you should let the investment merits of your company stock, as well as your own diversification needs, be the primary drivers of when you decide to exercise your options and whether you decide to hold your company's shares or sell them. But tax considerations should most certainly be in the mix too. And even if you're a dedicated do-it-yourselfer, the topic of ISOs is such a complex one that you might seek advice from an accountant or financial advisor to help you determine the best time to exercise your options and whether to hold the stock or sell it.
Limit Other Income
Beyond private-activity muni-bond income and the "phantom" income you receive when you exercise stock options and hold the stock, income from other sources is treated pretty much the same under the AMT system as it is under the regular tax system. Nonetheless, upper-middle-class taxpayers (those with household income levels of $150,000 or more) tend to be the most vulnerable to AMT. Thus, if you find yourself on the cusp of this zone, it pays to do what you can to reduce your taxable income and therefore lessen the likelihood you'll be on the hook for AMT. Income-reducing tactics include maxing out your available retirement-plan contributions, using capital losses to offset current income, and stashing income-producing investments in your tax-sheltered accounts. All of these strategies make sense regardless of your tax predicament, but they're particularly relevant if the AMT is looming over your tax return.
Push Forward--or Defer--Your State and Local Tax Deductions
The AMT calculation doesn't allow you to use many of the deductions that are available to you under the regular tax system. One of the most valuable of these "lost" deductions is the deduction for state and local income taxes. Thus, if you expect that you'll be on the hook for AMT in one year and not the next (if you exercised options in 2008, for example, but won't do so in 2009), you might consider deferring your tax payments until the non-AMT year, thereby preserving the deductibility of these taxes. Of course, you're apt to be liable for a late-payment/underpayment penalty if you decide to go this route, because you'll essentially be paying late. So you'll want to be sure that your AMT-related savings will be great enough to offset any penalties you'll pay. Conversely, if you expect to be in the AMT zone next year but not this one, consider prepaying your state and local taxes to ensure that they're deductible on this year's return. As with timing your stock-option exercises, this is another area where it pays to consult with a financial professional lest you end up making a costly mistake.
Manage Other Deductions
In a similar vein, you can adjust the timing of other expenditures that would be deductible under the regular tax system but are not deductible in years in which you're subject to the AMT. For example, say you typically itemize miscellaneous expenses that amount to more than 2% of your adjusted gross income, including unreimbursed business-related expenses, tax-preparation expenses, and investment-advice costs. None of these deductions are allowable under the AMT framework. Thus, to the extent that you can, you should aim to push forward or defer these expenses to preserve their deductibility for years when you won't be subject to the AMT.
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Publishes January 2010
Christine Benz has a position in the following securities mentioned above: VWITX. Find out about Morningstar's editorial policies.