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How the Alternative Minimum Tax Works

        Money | Taxes

What is the Alternative Minimum Tax?

The Alternative Minimum Tax (AMT) is often described as a "shadow" or "parallel" tax to the regular federal income tax. The name, in fact, says it all; the AMT is an "alternative" way of calculating income tax. The IRS requires middle- and high-income taxpayers to run two sets of numbers when filing income taxes: the regular income tax calculations on Form 1040 and the AMT method on Form 6251. Whichever number is higher is the amount the taxpayer must pay. Unfortunately for a growing number of Americans, the AMT is the winner.

Why is that unfortunate? Because the AMT bill can be much higher than what is owed under regular tax law. What the AMT attempts to do is strip away special deductions and exemptions and start every taxpayer off on equal footing. Under the AMT, everybody starts with the same large exemption, which in 2011 is $48,850 for single taxpayers and $74,450 for married couples filing jointly. That means a married couple doesn't owe a cent on the first $74,450 of its income. But any income that exceeds $74,450 is taxed at 26 percent. If the couple's income exceeds the exemption by $175,000 or more, it is taxed at 28 percent.

On the surface, that sounds pretty fair. After all, the regular income tax rate for $75,000 is 25 percent and the rate for income exceeding $140,000 is 28 percent in 2011. But the truth is that many taxpayers can get their total taxable income much lower if they are allowed to use the exemptions and deductions in the regular tax code.

For example, the following common (and often large) deductions are NOT allowed for AMT purposes:

  • The personal exemption ($3,700 per family member in 2011)
  • The standard deduction ($11,600 for married filing jointly)
  • State and local income taxes, real estate taxes and property taxes paid the previous year
  • Interest on a home equity loan not used to purchase or improve a home

And those are just the most common deductions outlawed by the AMT. There are others that can dramatically raise the taxable income of certain taxpayers. For example, if you incur a lot of unreimbursed employee business expenses from your job, you're allowed to deduct a portion of those expenses under regular income tax law. Not the AMT [source: TurboTax].

Also, if you are offered incentive stock options from your employer and you choose to exercise those options, the AMT charges income tax on the difference between the price you pay for the stock option and the market value of the stock. Under normal tax law, you're only taxed when you sell the stock, and even then the rate is 15 percent for a capital gain, not 26 percent [source: TurboTax].

Because of the AMT's alternative rules about exemptions and deductions, more and more taxpayers are falling into its grasp. In the next section, we'll look at who exactly is paying the AMT and why.