Over the last couple months I have flown with many people who were angry about their high tax bill. Two things they all had in common are that they hated the additional AMT tax, and they didn’t understand it very well. Today I will try to demystify the AMT tax and show how it can work in your favor in certain situations.

Some History

As many of you probably know the AMT was originally designed to get tax payers, using various tax sheltering strategies, to pay their fair share. It was actually a very good system for doing that, as the AMT is very hard to avoid. Unfortunately the exemption amounts were never adjusted for inflation. It literally took an act of Congress each year to keep the AMT from reaching “middle income” tax payers. Again, unfortunately, Congress didn’t keep up, and today the AMT reaches many people it wasn’t originally designed for. A couple years ago Congress finally “fixed” the AMT, allowing the exemption amounts to adjust for inflation, but it will now repeatedly affect those who find themselves paying it.

The AMT

In the tax code there are two completely different set of rules that tell you how much income tax you owe. Whether you know it or not, every year you calculate your taxes due under both sets of rules and pay the higher amount.

Compared to the regular tax code, the AMT is actually very simple. First you add up all your income, take a very select few deductions, take one large exemption and pay 26% on the first $175,000 and 28% on the rest.

Let’s look at a hypothetical couple to illustrate the difference. They are a family of five who file Married Filing Jointly. They have W2 income of $200,000, pay $10,000 in mortgage interest, $8,000 in state income tax, $20,000 in property tax and have $10,000 in miscellaneous deductions (subject to the 2% floor). Here is what their calculation looks like under the regular tax system in 2014.

Now under the AMT system.

In our example they owed $4,456.50 in additional tax due to the AMT being the higher amount. This number is what would show up in Form 1040 under AMT tax.

AMT Planning Strategy #1

If you are like a lot of people paying this additional tax will make your blood boil, and you want to know a way to lessen the impact of AMT. While Congress did a good job of making the AMT very hard to avoid, there are a couple of strategies to employ.

The first one is to avoid taking deductions this tax year that you have the ability to take in later years, which will be lost in the AMT calculation. One example of this is for taxpayers who have a property tax due at the end of the year. If you have the ability to pay it in early January instead of late December you will be delaying the deduction until next year. Eventually you may, say in retirement, be able to finally take that deduction you keep putting off when your income is lower.

AMT Planning Strategy #2

Along with losing various deductions with the AMT tax, you also lose all of your dependency exemptions. This means that it doesn’t matter if you have 10 dependents or 0. If you have older children who earn their own income it may be beneficial to not claim them as a dependent and have them file as an individual (not a dependent). This will allow them to take a larger deduction and save on their taxes, while not increasing yours.

AMT Planning Strategy #3 (All figures are for Married Filing Jointly filers)

This one requires us to dig a little deeper into the AMT calculation. The normal exemption amount for the AMT is $82,100. Once your AMT taxable income reaches $156,500 you lose $0.25 of exemption amount for every $1 of income above this threshold. This is why our AMT exemption in our example above was $73,725. While this exemption is being phased out by the reduction above, this can increase the normal 26% and 28% tax brackets to almost 35%.

Let’s see an example of this. Our couple above wants to take out an additional $50,000 out of their 401K to buy a sports car this year (they meet the requirements so no additional penalties apply). Below is what their AMT calculation looks like, which is the one they will end up paying.

Their total tax due increased by $16,250 by adding $50,000 in earnings, or a tax rate of 32.5% on the additional $50,000. This increase in marginal tax rates while the AMT exemption is being decreased is sometimes referred to as the “AMT bump” and should be avoided if possible.

Now let’s see how we can plan around the “AMT bump”. Part way through the year our couple decides to take out an additional $300,000 out of their 401K to pay off their lake house (total interest paid is now only $5,000 for the year). They calculated this will save them money by no longer paying interest to the bank. This pushes up their gross income to $500,000. Below is the calculation for the AMT tax system, which again will be the one they will end up paying.

That sports car still seems like a good idea to them, so they decide to take an additional $50,000 out to buy it.

Now that they are done phasing out their AMT exemption they only paid an additional $14,450 by adding $50,000 in income or only 28.9%. This may actually be a good strategy to take additional money out of the 401K this year because 28.9% is a pretty low number if their income will stay high. Buying the sports car is another decision, however. A Roth conversion may be the smarter choice.

In the last example the AMT tax system was barely higher than the non-AMT (“regular”) tax system increasing taxes by only $99.09. Let’s see what happens if we want to buy a pair of sports cars and add another $50,000 to our income for a total of $600,000. Below is a calculation of the regular tax system which will now be the one we will have to pay (I assume state taxes are 4% of gross income).

The regular tax rules get more complicated at this income level, but eventually we get to the total tax due of $171,602.91. This is $19,952.91 more tax by adding an additional $50,000 on gross income or 39.9%. As you can see once we venture back to the regular tax system the marginal tax rates for additional income are much higher. If you are going to employ this strategy make sure you keep yourself at the AMT rate (past the “bump” but before the regular tax kicks back in).

The AMT tax is almost impossible to avoid, but with the right financial planning there are ways to minimize the overall taxes you and your family will have to pay over the long term.