Trapped By A Tax?

The deadline for filing taxes is just six weeks away. Though you may not know it, buried under your tax papers is a potential pitfall, one that could end up costing you money. It's the Alternative Minimum Tax, and an increasing number of Americans are getting caught in its crosshairs.

The Early Show financial adviser Ray Martin explains.

Over 35 years ago, the Congress enacted a change to the tax code that required certain taxpayers to refigure their tax liability without a number of tax deductions and exemptions that were allowed under normal circumstances.

This change was enacted over concerns that 155 wealthy families were using too many tax loopholes to avoid paying ANY federal income tax. That change, called the Alternative Minimum Tax, or AMT, now snares a rapidly growing number of middle income taxpayers, causing them to pay billions in additional federal taxes, thus raising concerns over an unintended consequence of more moderate income taxpayers being trapped into paying this additional income tax.

The objective of the AMT is to increase your tax if using certain tax deductions and exemptions would cause your regular income tax to be lower than if the tax benefits were added back in to your income and the tax were calculated under an alternative rate.

The problem is that since the regular income tax rates were reduced in 2003, the AMT rates were not also reduced, thereby causing more middle income taxpayers to be snared by the AMT. In 2003, about 2.4 million taxpayers paid $8.7 billion in additional income tax under the AMT. According to the Tax Policy Center, the number of taxpayers paying additional tax due to the AMT will rise to 3 million in 2004, 18.4 million by 2006, and 24 million by 2008. Under their projections, a whopping 29.4 million taxpayers could be affected in 2010!

Who Is An AMT Candidate?
Generally, any taxpayer reporting $75,000 to $85,000 or more of adjusted gross income might be subject to the AMT. In 2004, approximately 1.5 percent of taxpayers with income between $50,000 and $100,000 are expected to be affected. But in just six years, over 68 percent of this group is expected to be paying additional income tax due to the AMT. This explosion of additional tax on the middle class is what is getting a lot of attention.

Of course, Congress is aware of this problem, but any solution will be a challenge as it will take away funding for a federal budget that is already steeped in red ink.

A simplification of how the AMT works is that you begin with your taxable income, which is figured the regular way, and then add back any adjustments and deductions that are not allowed under the AMT.

The most common deductions that are disallowed are for state income taxes, property taxes, home equity loan interest deductions, and personal exemptions for dependents.

This higher income amount is then reduced by the AMT exemption, which is $58,000 for joint filers and $40,250 for single filers. The result is the AMT taxable income, which is then multiplied by 26 percent for AMT income up to $175,000 ($87,500 for single filers) and 28 percent for AMT income over that amount.

As a general rule, taxpayers who live in states with higher state income tax, and pay high property taxes and claim an above average number of dependents are in the high risk group of being subject to the AMT.

One interesting detail is that over 50 percent of the taxpayers currently paying the AMT live in one of four states: California, Massachusetts, New Jersey and New York – all states where high state income taxes and high property taxes are common.

AMT How To
Taxpayers are required to recalculate their income tax under the AMT by completing Form 6251. If the AMT is more than the tax calculated under the regular way, then the excess AMT is reported on line 44 of their form 1040. The bright side, if there is any, is that most tax preparation software will automatically complete the Form 6251 and calculate the alternative minimum tax for you. On some programs, though, you have to select the form to do this.

For many taxpayers, their returns are prepared by a tax professional, and if they do not carefully review it, they may not even know they are paying additional tax under the AMT. Taxpayers can find out if they have been affected by the AMT by checking line 44 of their tax return. If the AMT has been correctly calculated, they will find the amount owed there.

Tax Strategies To Minimize Your AMT
Unfortunately there are few "silver bullets" for taxpayers who get tangled up by the Alternative Minimum Tax. The overall strategy involves either reducing deductible expenses, not claiming exemptions or increasing income. The objective of these strategies is to drive up your taxable income under the regular calculations, so that your regular income tax is more than the AMT.

A few tax-planning strategies to consider are:

• Move to a state with lower or no income taxes.
• Lower your property taxes by selling a larger home and buying a smaller one.
• Pay off a home equity loan/credit line debt, which was NOT used to buy, build or improve a home.
• Don't claim dependent exemptions for college-age children, allowing them to claim themselves and possibly claim education related tax credits.
• Sell municipal bonds where the interest is potentially subject to the AMT (called private activity bonds).
• When exercising incentive stock options, sell some shares to realize income on the share gains.
• Reduce income from investments, particularly qualified dividend income, which is taxed at the lower 15 percent tax rate.