I would love to have written "peace," but there is nothing peaceful about the Alternative Minimum Tax (AMT).
One of the best gifts of the Tax Cuts and Jobs Act (TCJA) was significant reform that decimated the AMT for many taxpayers who previously had the "privilege" of paying this covert tax. While the AMT wasn't completely killed, it was sedated enough that most taxpayers don't have to worry about being bitten by it, as the probability is very high that they will no longer be subject to the AMT in 2018 and future years.
The Tax That Was Anything But Minimal
The AMT adds complexity when preparing your taxes as you are required to calculate it in addition to the regular tax calculation. Whichever calculation results in a larger tax liability is the amount you get to pay. Brilliant, isn't it? The AMT calculation differs from the regular tax computation by disallowing many common itemized deductions. Generally, the AMT rates are either 26% or 28%. Sounds fairly simple right? Not so fast. Let's continue.
Congress created the AMT in 1969 to ensure that the wealthiest taxpayers paid a minimum amount of tax. It was proposed following testimony by the Treasury secretary that more than 150 people with adjusted gross incomes above $200,000 (equivalent to about $1.5 million today) had paid $0 in federal income tax on their 1967 tax returns. Congress viewed this as unfair and added the AMT calculation to ensure that all citizens were required to pay what Congress thought was an acceptable level of tax.
Initially, the AMT applied to the nation's wealthiest taxpayers, but fast forward to 2015 and more than 10.3 million wealthy and middle-class households were subject to the AMT.
The primary reason for that massive shift relates to the AMT exemption, which is a sort of standard deduction for the AMT calculation. This AMT exemption was not adjusted for inflation for many years. In 2017, the exemption amount was $84,500 for joint, married filers and $54,300 for single filers. Additionally, the AMT exemption also phases out once your household income reaches certain thresholds. The phase-out thresholds for 2017 were $160,900 for joint, married filers and $120,700 for single filers.
The combination of these effects made it very difficult to determine the actual amount of tax that was being paid. While 26% and 28% were the stated AMT rates, they were rarely paid. The phase-out of the exemption often meant that taxpayers actually paid 33% or 35%. The covert nature of this tax was at its worst when it came to realizing capital gains. Investors would sell stock and incorrectly assume they were paying tax at the 15% or 20% rate on long-term capital gains. Instead, the real rate ended up being 22% or 27% because the capital gains increased income, resulting in the phase-out of the AMT exemption. Not so simple now, is it?
What Changed with the New Tax Law
The TCJA of 2017 significantly altered the AMT by modifying the AMT exemption and phase-out rules. The AMT exemption increased from $54,300 and $84,500 for single and married filers to $70,300 and $109,400, respectively. More importantly, however, the new tax law increased the threshold for the phase-out of the exemption from $120,700 and $160,900 for single and married filers to $500,000 and $1 million, respectively. Both the AMT exemption and phase-out rules will annually adjust for inflation, however, these changes only apply until Dec. 31, 2025, when these rules revert back to their old amounts.
Beyond these rules, certain itemized deductions made you more likely to pay the AMT: the deduction for state and local income and property taxes, and/or a high amount of deductions subject to the 2% of AGI limitation (i.e., unreimbursed employee expenses, tax-preparation fees and other professional fees). Since the deduction for state and local income and property taxes is now limited to $10,000 and the 2% of AGI deductions are eliminated, these AMT adjustments are no longer likely to make you subject to the AMT.
Who's Likely to Be Subject to AMT Going Forward
While the AMT was technically not eliminated from the tax code, for practical purposes it was for the majority of taxpayers. If you were subject to AMT in 2017, you will most likely not be subject to it in 2018. Let's look a bit deeper across three cases where a married taxpayer lives in a high-tax state and reports $300,000, $400,000 and $600,000 of income. Let's also assume this taxpayer claims itemized deductions of their state income taxes plus $5,000 in real estate taxes. The results are summarized in the table below.
AMT Case Studies Summary
Case #1 Case #2 Case #3
(wages, social security, pensions, IRA distributions, etc.)
|Dividends/Long-Term Capital Gains||$200,000||$200,000||$200,000||$200,000||$400,000||$400,000|
|Adjusted Gross Income||$300,000||$300,000||$400,000||$400,000||$600,000||$600,000|
(Regular + AMT)
|AMT Included Above||$2,946||$-||$12,074||$-||$22,572||$-|
|% decrease in Federal Tax||9%||18%||16%|
|Marginal Rate - Federal||26%||12%||26%||24%||28%||24%|
|Effective Rate - Federal||16%||15%||22%||18%||23%||19%|
In all cases, the taxpayer stopped paying AMT in 2018. This contributed to a reduction in the federal tax liability by 9% to 18% across the cases, even though the taxpayer ended up claiming less deductions (standard in 2018 vs. itemized in 2017). Most importantly, however, is that marginal rates decreased, making 2018 and future years a great time to potentially reduce or eliminate taxes from your retirement .
Despite these changes, a few taxpayers will still find the AMT to be part of their financial life. The most common will be:
- individuals who exercise Incentive Stock Options (ISOs)
- oil and gas investors who have depletion and intangible drilling costs
- investors owning private activity bonds
- and business owners with assets having different depreciation lives for regular versus AMT purposes
Some Possible Investment Moves to Consider
As part of a comprehensive review of how the TCJA impacts your personal situation, the structure of your investment portfolio should not be left behind. With regard to the equity portion of your portfolio, investors will want to re-evaluate the types of securities they own. Tax-efficient investors typically want to control and minimize the amount of capital gains realized each year. For individuals previously vulnerable to AMT, this was critical. Now that this is a much less likely to occur, investors should evaluate if different security types provide economic benefits that generate better after-tax returns.
With regard to the fixed-income portion of your portfolio, investors will want to re-evaluate their ownership of tax-exempt vs. taxable bonds. Many investors subject to AMT owned tax-exempt bonds to avoid the AMT exemption phase-out that occurs when interest income from taxable bonds is earned. Since there is now more capacity for taxable interest before AMT would apply, taxpayers will want to understand their after-tax rate of return on income investments as the spread between tax-exempt and taxable bonds may have closed considerably. Additionally, many investors subject to AMT also avoided owning Private Activity Bonds (PAB) as they were an AMT add back. They still are, but given the larger AMT exemption and high income phase-outs, investors will now likely have more capacity for owning these bonds before becoming subject to AMT.
It Could be Time to Restructure Fee Arrangements with Your IRAs
Many investors purposely paid the fee of their traditional and Roth IRAs out of a non-qualified investment account in order to maximize the income tax deduction for investment management fees. To the extent this amount, plus the other miscellaneous deductions exceeded 2% of AGI, the individual would have received a financial benefit, but only up until this deduction made the individual subject to AMT. Now that this deduction is no longer allowed, investors will want to evaluate the account(s) from which their investment fees are paid to optimize the tax benefits afforded these accounts. In most cases, investors will want to pay their traditional IRA fee out of their traditional IRA instead of the non-qualified investment account.
Will AMT Become Frankenstein Again?
As was previously noted, the AMT relief provided by the new tax law is temporary, with a scheduled termination date of Dec. 31, 2025. Consequently, if Congress does nothing, the AMT will resuscitate itself and live to terrorize another day. In the meantime, let's enjoy this eight-year vacation from AMT and make a point to take advantage of the potential opportunities that exist.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal adviser.
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