The real tax nightmare
Millions of taxpayers discover they owe a little known, but more expensive, tax.
New York (CNN/Money) - Bob Reilly is just a middle-class schoolteacher trying to get by.
Sure, his family's earnings total $100,000 a year. (His wife works in a doctor's office). But that doesn't go far when you're paying $10,800 in property taxes, $5,600 in state income taxes, $14,000 in federal taxes -- plus raising five kids and paying off a mortgage in Miller Place, Long Island.
Of course, the Reillys -- like many middle-class taxpayers -- used to write off many of those big expenses on their federal income tax forms. But this year, they were prohibited from claiming many of the most valuable deductions that normally would take the sting out of their tax bill. As a result, the couple's federal tax refund was slashed by $3,400.
"We used to get a considerable amount back. But it's been cut substantially," said Reilly. "We're just trying to make ends meet."
They're not alone.
Parallel tax system with its own rules
As the current tax season draws to a close, a full 2.4 million of taxpayers are discovering that they, like the Reillys, are subject to an expensive tax system known as Alternative Minimum Tax or "AMT."
A sort of "parallel" system to the standard tax code, the AMT has its own set of tax rules, tax rates and a complicated formula for computing what you owe Uncle Sam.
But what makes the AMT so punishing is that it prohibits filers from claiming the most basic of middle-class write-offs. These include such items as state and local income taxes, property taxes, miscellaneous itemized deductions, mortgage interest on certain home equity loans and standard deductions for kids and for filers themselves.
Congress created the AMT in 1969, as a means of punishing wealthy Americans whose abuse of deductions and loopholes allowed them to avoid paying any income taxes. By limiting deductions, the AMT was intended to force "the rich" to pay at least some nominal amount of tax.
More than three decades later, however, the scheme's biggest flaw has become maddening: there's no set income cut-off to know when the AMT kicks in. A modest income with many deductions might trigger it faster than a magnificent salary with few deductions.
Needless to say, those who suddenly lose their tax breaks to the AMT are often caught off-guard.
"People don't expect it," says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young. "The presumption is that when you pay taxes that are deductible you won't have to pay tax again. Just having a lot of kids can put you into the AMT."
The mainstream gets hit
The only way for taxpayers to know if the AMT affects them is by computing their taxes -- twice. Once, under normal rules, and again, following AMT guidelines.
Under traditional rules, individuals subtract certain tax breaks from their income to reduce their tax liability. They then apply the correct "marginal" tax rates -- which range from 15 percent to 38.6 percent -- to figure out what they owe the IRS.
Under the AMT, individuals get to claim far fewer deductions from their income so more of it is subject to tax. Then, depending on the amount of their AMT income, an "alternative" tax rate is applied at either 26 percent or 28 percent.
If it turns out that filers owe more following AMT rules, then that's what they have to pay.
Given the cost and complexity of the AMT it may be tempting for individuals simply to file their taxes without bothering to see if they owe AMT. Bad plan: the IRS computers can easily catch those who attempt to evade the tax.
"They'll be able to figure it out and they'll send you a bill, plus interest and potentially a penalty," says Ernst & Young's Nissenbaum. "You can't avoid AMT by saying you won't fill out the form."
Soaking the middle class, too
With that in mind, tax experts are warning individuals that they need to watch out for AMT -- even if they aren't rich.
Take Steven Santarcangelo of Pompano Beach, Florida. A single dad with three kids, Santarcangelo earns $55,000 a year, rents his home and had "never even heard of" the AMT until a few months ago. That's when his accountant informed him that his tax rebate would be reduced by $140 because he owed AMT.
Santarcangelo was stunned -- and infuriated. The $140 may not be a vast sum of money, he admits, but it's still enough to make a difference in his life. "Like everyone else, I've got bills to pay, car payments," he says. "They're killing us."
Such laments are only going to grow louder. By 2010, some 35.5 million taxpayers will be paying the tax. Meanwhile, those who are most vulnerable to it will hail from the ranks of the middle-class, not the super-rich.
These days, for example, only 1.4 percent of individuals like Santarcangelo -- whose incomes fall between $50,000 and $75,000 -- pay AMT. By 2010, however, a full 43 percent of this group will owe it, according to analysis by the non-partisan Urban-Brookings Tax Policy Center.
Those who earn up to $100,000 will fare even worse. By the end of the decade, 79 percent will owe AMT, up from the 3 percent who do so today.
Waiting on Congress
Those hoping for a solution from Congress may have a wait.
The AMT is a huge headache for those who are stuck with it, but it still has not garnered the kind of public attention as, say, proposals to eliminate dividend or estate taxes. Without political will, there's little incentive for reform. Indeed, the AMT generates billions of dollars for the federal government, and it will only become more expensive to "fix" the problem in years to come.
These days, for example, the AMT generates $13 billion -- or 1.4 percent of taxes -- for the federal treasury. By 2010, it is expected to produce $141 billion -- or a full 10 percent of total tax revenues.
If Congress were to allow taxpayers who owe AMT to deduct their state taxes, miscellaneous itemized deductions and claim personal exemptions on their returns - the government would give up $134.2 billion in 2010 alone -- or some 95 percent of AMT revenues it's banking on.
By comparison, the repeal of estate taxes in 2010 -- a hot-button issue that's generated plenty of controversy and attention -- seems like a bargain. In that year, that repeal will cost the $53 billion, according to the Joint Committee on Taxation.
That's not to say there haven't been efforts to reform the system. "There was a proposal in Congress that would raise a point of order against any tax proposal that would not deal with the AMT," notes Leonard Burman, co-director at Tax Policy Center. "It died."