The ABCs of the AMT

In Lesson 18

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Maybe you've managed to ignore the recent spate of tax-reform stories, but that doesn't mean you'll dodge the Alternative Minimum Tax or its higher tax bite.

The AMT system comes with a completely different set of rates and deduction rules. People pay it only if their AMT tax amount is higher than their traditional taxes. Translation: If you're paying the AMT, you are by definition paying higher taxes.

The system created to make sure the uber-rich didn't dodge the tax bullet is under fire because it's now affecting middle-class Americans. And reforming it could mean increased tax payments for everyone.

The problem? What defined uber-rich in 1969, when the AMT was first enacted, has never been adjusted for inflation. That means what made you affluent back then doesn't now - but you're still taxed like it does.

The Urban-Brookings Tax Policy Center estimates that just more than 4 million taxpayers will owe AMT on their 2008 tax returns. If Congress doesn't act, that number will rise to more than 33 million in 2010.

To give you a sense of just who might get caught, nearly 46% of the households with incomes between $75,000 and $100,000 will pay AMT by 2010 versus 0.5% in 2008, assuming Congress does not act.

Under the regular IRS rules, you start with your gross income and subtract deductions like state taxes you paid, and exemptions like child credits. Eventually, you arrive at your taxable income.

Under AMT rules, you still start with your gross income, but many of the usual deductions and exemptions are disallowed. Suddenly, your taxable income is a lot higher.

Even though some deductions still stand, including those for mortgage-interest and charitable donations, some key breaks are lost. They include: state and local income taxes and property taxes; child-tax credits; and home-equity loan interest.

Even though the highest tax rate under the AMT - 28% - is lower than that in the regular tax system - 35% - AMT victims are paying more because they're paying on a greater amount of taxable income.

Short of moving to a low-tax state like, say, Texas, said Len Burman, co-director of the Tax Policy Center, there's not a lot you can do to avoid AMT's clutches.

In trying to determine tax liability under AMT, you do get to exempt a certain amount of income from your calculations.

The problem is that the exemptions granted under the AMT have not kept pace with inflation - while the average paycheck has. For instance, in 1982, the exemption for married couples filing jointly was $40,000. Adjusted for inflation, that would be $103,119 today.

Currently, the exemptions are only $69,950 for married couples filing jointly and $46,200 for singles. And they would be even lower if Congress didn't vote through a "patch" every year.

Really high earners may not even get the full exemption since it is phased out above certain income levels.

For tax year 2008, the phase-out for married couples filing jointly begins at $150,000 (after the deductions that are allowable). The deduction shrinks by 25 cents for every dollar earned above that amount until finally, at $429,800, there is no exemption at all.

By law, everyone who files taxes is obligated to figure out whether they have to pay AMT, and they are prompted to do so on line 45 of Form 1040.

There, taxpayers are referred to the AMT worksheet. If the taxable income on the worksheet is higher than the taxable income on the 1040, you are subject to AMT and must fill out the special AMT Form 6251.

But the worksheet and Form 6251 can be daunting, and 75% of AMT payers hire a professional to do their returns, according to the President's Advisory Panel on Federal Tax Reform.

"The first time most people hear about the Alternative Minimum Tax is when they get a letter from the IRS saying that they still owe money," said the Tax Policy Center's Burman.

So how do you know if you'll be one of the unlucky?

If your total deductions and exemptions under the normal tax code come close to the AMT exemption, you want to be on the lookout for the AMT, said Tom Ochsenschlager, vice president of taxation with the American Institute of Certified Public Accountants.

The IRS also offers "AMT Assistant," an online tool that helps you determine whether you need to pay the AMT.

Also be on the lookout if your adjusted gross income changes dramatically because of: a lot of itemized deductions; high local and state tax deductions; child exemptions; or a mortgage deduction.

NEXT: The dreaded audit

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