How to Control Your AMT Exposure
Be aware of the common triggers for the AMT--and take steps to minimize them.
Investing Specialists
Note: This article is part of Morningstar's February 2014 Tax Relief Week special report. An earlier version of this article appeared Oct. 1, 2009.
Like a Sudoku puzzle, the Alternative Minimum Tax is a matrix of different variables that can be hard to fully understand. 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 the AMT fall into one of two groups. The first factors are those that increase the income that's subject to the 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.
Some taxpayers fall into the AMT zone year after year, and there's no getting around it, especially if they fall into the AMT-susceptible income bands, have a lot of stock options, and/or live in a state with high taxes. (State and local taxes, as well as real estate taxes, are not deductible under the AMT system, but they are deductible under the regular tax system.)
Nonetheless, it may be possible to exercise control over some of the factors that make you susceptible to the AMT. 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 become subject to the AMT in more years than necessary.
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). 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. Fidelity Tax-Free Bond (FTABX) and Vanguard Intermediate-Term Tax-Exempt (VWITX) are Gold- and Silver-rated options, respectively. (Just bear in mind that the Fidelity fund lands in our long-term category and, therefore, courts considerable interest-rate risk.)
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. Of course, 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 well versed in them 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 the 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 the 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. (Those are all good tax-minimization ideas whether you're in the AMT zone or not, so there's little downside to putting them into practice.) Reducing realized capital gains--as Morningstar's Adam Zoll discussed in this article--can help you preserve your AMT exemption, which begins phasing out for single taxpayers with $115,400 in income and married couples filing jointly with more than $153,900 in income.
Controlling Deductions
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 2013, for example, but won't do so in 2014), 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 to help you avoid 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 is 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.
MIC 2014 Ad Module  | Morningstar Individual Investor Conference March 22, 2014 | 9:00 a.m. CDT Position your portfolio for success with the help of Morningstar's investment experts.  |