Alternative Minimum Tax

The alternative minimum tax (AMT) was established in 1969 to make it harder for the wealthy to avoid paying income taxes through write-offs and tax shelters. However, the AMT has become a problem for middle- to upper-middle-income people in recent years because its exemption amounts have not kept up with inflation. Ironically, deductions that were introduced to cut taxes for middle-income families have caused some of these families to be lumped together with tax-evading fat cats under AMT rules.

The AMT usually affects individuals and small businesses that take many exemptions and deductions, such as exemptions for dependents or deductions for state and property taxes. Therefore, large families and people living in high-tax states like California or New York are more likely to pay the AMT. Exercising incentive stock options or selling property can also result in large AMT bills.

Under the AMT, individuals are taxed at rates of 26% and 28% on all taxable income above the exemption amounts. The Tax Increase Prevention and Reconciliation Act (TIPRA) set the 2006 AMT exemption amounts at $62,550 for married couples filing jointly and $42,500 for single filers. This law also allows taxpayers to use nonrefundable personal credits, such as education and dependent care credits, to offset AMT liability.

Taxable income is calculated differently under AMT rules than under the regular tax code. The AMT system does not allow personal exemptions for an individual or dependents, deductions for state and property taxes, deductions for interest on a second mortgage, or other common write-offs such as out-of-pocket business expenses. Here are some tips for minimizing your AMT liability:

    1. Accelerate income and defer deductions. If you can arrange it, have your salary and bonus paid in advance and take deductions in a year when you are less likely to be subject to AMT. The more income you have relative to your deductions, the less you will pay in AMT.

    2. Be careful when cashing in investments; a large capital gain can wipe out all or part of your AMT exemption.

    3. Consider the tax implications before exercising incentive stock options (ISOs). You may have to pay AMT on the spread between the stock option exercise price and the fair market value (FMV) of the shares if you fail to dispose of them in the same year.

    4. Avoid investing in state and local municipal bonds that finance "private activities," such as the construction of sports stadiums or hospitals; interest from these bonds is not tax-free under AMT rules.

While the AMT is on the books, you should stay aware of the implications and do what you can to minimize your AMT liability. Consult your tax professional for more specific advice.

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