In 1969, it came to the attention of the federal government and the public that there were 155 tax return filers with incomes of $200,000 — equivalent to an annual income of more than $1.3 million in today’s dollars — who paid no federal income tax.
While their $0 tax liability was legal within the tax code at the time — they were using federally allowed income deductions and tax breaks appropriately — the government was embarrassed and moved quickly to legislate a solution. From this the AMT, or Alternative Minimum Tax, was created, with the aim of making the tax system fairer.
It exists in parallel with the current income tax system and mandates that many taxpayers must calculate their taxes owed by using an “alternative method” as well as the traditional method — and pay the higher of the two tax amounts calculated.
While the tax cuts of the Reagan era eliminated most of the original deductions that led to its creation, the AMT has remained intact to this day.
Because the level of income that triggers the AMT has not been adjusted to today’s income levels, the AMT now affects an increasing number of middle-income households more than those with the very highest incomes most similar to the original 155 tax filers it was created to catch.
Rather, people who benefit most from ordinary tax deductions — married couples, those with large families and those who live in high tax states (because state income tax deductions are not allowed in the AMT) — are more likely to get hit with the AMT.
It’s not unusual for single taxpayers with ordinary income over $500,000 in a low-tax state to escape the brunt of the alterative minimum tax while a couple with children making a combined salary of $200,000 gets hit.
In 2001, slightly more than 53% of households with annual incomes of over $200,000 paid the AMT. Only 33.5% of those making an annual income of $1 million did.
How Does the AMT Work?
The name describes how the tax works. It’s an alternative set of rules for calculating your federal income tax. The rules determine the minimum amount of tax your income requires you to pay. If you’re already paying at least that much because of the regular income tax, you don’t have to pay AMT. But if your regular tax falls below the minimum, you have to pay the higher AMT amount.
The AMT takes away certain breaks allowed by the regular income tax system. Under AMT, these tax deductions are eliminated:
- Your regular personal exemption;
- Dependent exemptions;
- Deductions for state and local taxes paid;
- Deductions for home equity loans unless used to improve your primary residence; and
- Miscellaneous itemized deductions.
Basically, many of the deductions that you can claim to figure out your regular tax bill must be added back. Once you add back in these disallowed credits and run the numbers, you might be subject to a bigger IRS bill if your taxable income exceeds the annual AMT exemption amount for your filing status.
The AMT exemption is like a standard exemption for calculating the tax owed. In 2016, the exemption amounts are $53,900 for singles and $83,800 if you’re married. For 2017, the amounts increase to $54,300 and $84,500, respectively. The AMT calculation then gets more complicated by adding in several adjustments involving depreciation deductions, among other things.
Unfortunately, there’s no easy way to figure out if you’ll be subject to paying the AMT. Everyone’s tax situation is different and what goes into the calculations is uniquely personal. To complicate things, there’s no specific income threshold at which the AMT kicks in.
A good place to start is the AMT Assistant for Individuals calculator on the IRS website. You can also get a good handle on whether you’ll be subject to AMT or not by using tax-planning software such as Turbo Tax to run projections and monitor your tax liability. Or you can hire a tax accountant to run projections for you.
Another way to estimate if you are close to getting hit with the AMT is to calculate last year’s taxes using Form 6251 and see where your income will fall in relation to them this year. The Fairmark’s Guide to AMT can also be helpful.
Unfortunately, the AMT is a dreaded reality for more and more middle-income American taxpayers. This is in part because it was never indexed to inflation each year, as regular income tax is. One inflation calculation shows that making $200,000 in 1969 is equivalent to making $1,315,275 in 2016. Yet, today’s households with incomes between $200,000 and $500,000 appear to be the most vulnerable to getting hit with the AMT.
As a taxpayer, you are required to figure out if you owe any additional tax under the Alternative Minimum Tax system by completing IRS Form 6251. If the tax calculated on Form 6251 is higher than that calculated on your regular tax return, you have to pay the difference as AMT — in addition to your regularly calculated income tax.
If the calculations show you must pay the AMT, paying the extra amount combined with the extra paperwork hassle is not fun. But it’s better than dealing with the IRS if an audit shows that you should have paid and did not. The IRS charges interest on unpaid taxes and assesses penalties.