Is the AMT Costing Me More in Capital Gains Taxes?

Note: This article is part of Morningstar’s February 2014 Tax-Relief Week special report. This article originally appeared Feb. 4.

Question: A friend told me he pays a 22% long-term capital gains tax rate because he falls into the AMT but would have to pay only 15% if he didn't. How can that be?

Answer: Technically what your friend said isn't quite true, though from a practical standpoint it very well may be. Sound confusing? Then welcome to the wonderful world of the alternative minimum tax, or AMT.

Your question is a timely one given the stock market's strong performance in 2013. As a result, many fund investors and others who sold assets at greatly appreciated prices may be looking at hefty capital gains tax bills. For those who pay the AMT, this may prove particularly painful and here's why.

A Parallel Tax System
As explained in an earlier Short Answer column, the AMT basically serves as a parallel tax calculation designed to keep taxpayers--the wealthy ones, in particular--from paying no or very low taxes through the use of tax deductions, exemptions, and credits. Taxpayers must calculate their taxes using both the conventional formula and the AMT formula, which has different exemption amounts and offers fewer deductions, and pay whichever amount is higher.

The treatment of capital gains is virtually the same in the AMT as it is in the conventional tax system. In the conventional system those falling in the 25% tax bracket or above pay long-term capital gains at a rate of 15% at incomes up to $400,000 for singles and up to $450,000 for those filing jointly, and at a rate of 20% at higher incomes. (Short-term capital gains are taxed at ordinary income rates.) Similar rules apply to dividends, with regular dividends taxed at ordinary income tax rates and qualified dividends taxed at the same rates as long-term capital gains. For both capital gains and dividends, an additional 3.8% Medicare tax is applied for single filers with adjusted gross incomes of at least $200,000 and those filing jointly with AGIs of at least $250,000.

So far nothing's different between how the AMT and the conventional tax calculation treat capital gains. But to understand where the difference lies, let's delve a little deeper into how the AMT is calculated.

The AMT Exemption: Doing the Math
The AMT uses the taxpayer's taxable income without applying many of the deductions allowed under the conventional income tax formula. Once this amount--called the alternative minimum taxable income--is calculated, the AMT exemption is then subtracted from it. For 2013 the AMT exemption is $51,900 for singles and $80,800 for joint filers. However, these exemption amounts phase out by 25% for any income above $115,400 for singles and above $153,900 for those filing jointly. Once the exemption has been subtracted from the taxpayer's income, this remaining amount is taxed at 26% up to the first $179,500 and then at 28% for anything above that. (This calculation is done on Internal Revenue Service Form 6251, which can be found here.)

The key to your question, and a potentially higher effective tax rate on capital gains under the AMT compared with the conventional income tax formula, is the 25% reduction in the AMT exemption at higher income levels. In other words, capital gains that add to this phase-out of the AMT exemption effectively amount to a greater tax on them than the 15% or 20% one would pay under the conventional income tax formula.

As an example, let's say a single taxpayer makes $115,400 in ordinary income from wages plus another $10,000 in income from long-term capital gains for a total of $125,400. Because the AMT exemption is reduced for any income beyond $115,400 for single taxpayers, anything above that amount--in this case, $10,000--reduces the AMT exemption by 25%. So instead of an exemption of $51,900 this taxpayer would have an exemption of $49,400, or $2,500 less than he would have had without the capital gains whittling away at the exemption. (The $49,400 exemption would be subtracted from the total income amount--$125,400--to determine how much of the total income is subject to taxes--in this case, $76,000.)

Next we'll focus on what this $2,500 reduction to the taxpayer's AMT exemption means in terms of his bottom-line tax bill. The reduced exemption essentially means that $2,500 more of the taxpayer's income is subject to the tax than would have been the case with the full exemption. This extra $2,500 of income is subject to the 26% AMT tax rate (remember that money left over after the exemption is applied is taxed at 26% up to $179,500 and then at 28% beyond that), meaning that the taxpayer ultimately ends up paying an extra $650 ($2,500 x 0.26) in taxes. Therefore, the taxpayer is already paying the standard 15% tax on his $10,000 in capital gains ($1,500) with an additional $650 thrown in from the reduced AMT exemption for a total of $2,150 in taxes from capital gains. Thus, it can be said that the taxpayer is effectively paying a tax rate of 21.5% on the $10,000 in gains. That's not quite the same thing as a 21.5% capital gains tax rate, but the ultimate effect is basically the same.

Investments and the AMT
Investors who pay the AMT and are leery of its added impact on capital gains might be tempted to tax-manage their portfolios accordingly, but this must be done with care. Peter Zich, a principal with Dugan & Lopatka, a Wheaton, Ill.-based accounting firm, cautions investors not to buy or sell securities merely to avoid paying the AMT. Waiting to sell securities until a year when you are not subject to the AMT could mean missing out on your sale price or being forced to sell at an inopportune time, he says, adding, "I don't want tax to control my investment decisions."

There are other ways to manage AMT exposure, however. Zich recommends that taxpayers focus on two tax years at a time to identify such strategies. For example, if the taxpayer won't have to pay the AMT this year but expects to do so next year--perhaps because of an anticipated large capital gains hit--he should take advantage this year of deductions that are available under the conventional income tax formula. So if a state or local tax bill isn't due until the start of next year but you anticipate having to pay the AMT then, pay the tax bill this year so you get the benefit of the deduction. (Such taxes aren't deductible under the AMT, but they are deductible under the conventional tax system.)

For investors who expect to pay the AMT every year, Zich suggests they look at their portfolios and make adjustments as needed. For example, AMT-paying investors who own private-activity municipal bonds that are taxable under the AMT but not the conventional income tax formula might consider lightening up on them.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.