Managing Your Exposure to the Alternative Minimum Tax

Jason Stipp: I'm Jason Stipp for Morningstar.

It's Tax-Wise Investing Week on Morningstar.com, and today we are talking about painkillers for those big tax headaches.

One of those headaches that may be increasingly afflicting investors is AMT. Here with me to offer some tips for managing AMT is Morningstar's Christine Benz, our director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Thanks for having me, Jason.

Stipp: So AMT is something that's increasingly afflicting a lot of investors, but I think above that, it's even just something that's difficult on its face to understand what it is. What is AMT, and why was it implemented?

Benz: Well, AMT stands for "alternative minimum tax," and it was originally instituted in the late '60s. The goal was to keep very wealthy taxpayers from using deductions and other loopholes to avoid paying taxes altogether. So, AMT is designed to ensure that people aren't able to skirt taxes.

Unfortunately, it has morphed into something that is probably not what it was originally intended to do, and has ensnared more and more middle-income taxpayers in recent years.

Stipp: So I know that Congress has tried to address this issue about the fact that it wasn't getting indexed [to inflation], but there are some changes in the way that that's happening in 2012, or some uncertainty anyway. What's the story this year with AMT?

Benz: Right. So year by year, Congress had been implementing what are called patches, essentially to keep new middle-income taxpayers from falling into the AMT. It has not acted yet for the 2012 tax year; Congress may act. But right now, there is a little bit of uncertainty. So it's possible that an even greater number of taxpayers will fall into the AMT zone for the 2012 tax year.

Stipp: So I know that the AMT is basically a different way of calculating taxes from the conventional way--that some people may have to pay if [the AMT calculation] actually shows the tax liability to be higher. But if I am worried about this or I think it could be an issue for me, how would I know? What are some qualities that might make me vulnerable to AMT?

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Benz: Unfortunately, it's not as simple as saying, "If you make more than X per year, you probably will be vulnerable to the AMT," because there are a lot other different factors that go into whether you do have to pay this tax.

But generally speaking, if your income is in the band of roughly $150,000 at the low end, up to about $500,000, that's kind of the sweet spot for people who are subject to the AMT. Over that, you are probably not going to be vulnerable. Under that, you may be. In fact, I have seen some taxpayers, even with household income levels in the $70,000 range, paying AMT. But being in that sort of $150K to $500K, that is the sweet spot for AMT.

Also, larger families who can take a lot of personal exemptions for each individual in the family under the traditional tax system, you can't take those personal exemptions under the AMT system. They tend to be more vulnerable than, say, married couples without children.

Stipp: I know one of the reasons that Congress initially enacted this was because they thought deductions were being overused. So does the amount of deductions that you take also potentially put you at risk for having to use this AMT system?

Benz: It does, Jason. So, if you are a person who, under the traditional conventional tax system, you're taking a lot of deductions, exemptions, credits, those are saving you money under the conventional tax system, but those may not be usable under the AMT system.

So, if your tax burden under the conventional system is lower than it is under AMT, then you'll have to pay the AMT tax. So, if you are someone who has been able to take advantage of a lot of those deductions, exemptions, and credits, that might make you more vulnerable.

Stipp: Another thing that investors should keep an eye on are incentive stock options. Why might that be a trouble spot?

Benz: Well it's tricky to understand, but essentially, if you are granted options at a certain share price and then you exercise those options, under the AMT system that is considered a gain to you, even if you haven't sold the shares. So even if you don't have that money in the pocket, that phantom gain, or what's called the bargain element, is taxable under the AMT system. That's why particularly in the '90s or early '00s, when a lot of people had those incentive stock options, that was a key trigger for being vulnerable to the AMT.

Stipp: So I think investors are probably looking at these things and wondering, Well, how can I manage this and try to at least blunt what could be a negative impact for me on the AMT? What steps can they take?

Benz: Well, there is no specific science to this, but in general, taking advantage of any steps that you can take to reduce your household's taxable income, so making charitable contributions, fully funding your company retirement plans, taking steps like that to reduce taxable income is a good first step.

Another thing to think about is if you are a municipal-bond investor, and you hold bonds that are called "private activity bonds," those bonds' income will be subject to the alternative minimum tax, even though the rest of muni bonds' income will not be. So be careful and pay attention to what your bond funds own, because if they do have a lot of the private activity bonds, that does make you more vulnerable to the AMT, if it's a big share of your household income.

Stipp: With those incentive stock options, is there anything that I should keep in mind about how I manage those? Or is that something I should check with my tax specialist about. It sounds complicated?

Benz: I think the best possible advice is to check with a tax advisor, a financial advisor. In some cases, you may be able to exercise those options on a staggered basis to avoid triggering a great big AMT tax hit in a single year. But I think this is something where someone who is well versed in handling incentive stock options can really earn his or her keep.

Stipp: We've also seen that those income-producing investments--you were mentioning maxing out, for example, the 401(k)--you might also want to think about your tax-deferred accounts as a good place for those, just to keep that income under control?

Benz: Absolutely. I think that makes a lot of sense.

Stipp: OK. Christine, so we know that unfortunately for some investors, AMT probably will be something that they have to face, either now or in the future. So, given it won't be necessarily something that would afflict you every year, how can you at least try to manage what you're doing this year or in future years depending on whether you fall in that bucket or not?

Benz: Right. As I mentioned, Jason, there are some deductions that you can take under the conventional system that you cannot take under the AMT system. So I think the big risk is if you fall under the AMT for a single year, you could have some very valuable deductions essentially going wasted, because you're not able to take advantage of them because you were in the AMT zone that year. So I think one strategy that people often talk about is, trying to bunch up those deductions into a year when you can actually use them, when you will not be subject to the AMT.

Another strategy that may be usable is for state and local income taxes as well as property taxes--those are not usable deductions under the AMT system. They are [usable] under the conventional tax system. So people may want to think about prepaying those taxes or deferring those taxes, just to make sure that they get to use them in a year when they're being governed by the conventional tax system and not the AMT tax system.

Stipp: All right Christine. It sounds very complicated, but potentially practical tips for trying to manage your AMT exposure. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.