What exactly is the alternative minimum tax? It is a parallel tax system originally designed by Congress to ensure that wealthy taxpayers who sometimes avoided paying regular income tax through heavy deductions ended up paying at least something. To calculate the AMT, taxpayers first calculate their regular income tax. Then they recalculate under the AMT method by adding back many of the deductions (called “preference items”) and adjustments they took when figuring their regular income tax. These items and adjustments might include miscellaneous itemized deductions, state income taxes, the exercise of stock options, home equity interest, personal exemptions and a higher medical deduction threshold. This is offset somewhat by the exemption of a certain amount of otherwise taxable income.

After the taxable AMT income is determined, the figure is multiplied by 26 percent on the first $175,000 (married couples filing jointly) and 28 percent on anything above that. Although the two AMT tax rates are lower than the regular income tax rates for higher-income taxpayers, more income is exposed to tax. Consequently, if the tax amount owed under the regular income tax calculation is less than the amount owed under the AMT calculation, you pay the AMT amount.

To date, the number of taxpayers paying AMT has been relatively small, and generally in higher income brackets. For the 2000 tax year, about 1.4 million taxpayers—slightly over one percent of taxpayers—paid AMT instead of regular income taxes. But Congress projects that number to jump to 2.7 million next year under the new act, 13 million in 2005 and 35 million by 2010! Some tax experts see taxpayers earning $75,000 a year or even less potentially exposed to AMT in the coming years. Especially vulnerable will be taxpayers in states with high state income taxes such as California and New York, taxpayers exercising stock options and those using tax credits to offset regular tax liabilities.

Why will so many new taxpayers be exposed to AMT under the new act? In short, the lower regular income taxes go, the more people fall under AMT because rates were not lowered for AMT and most of the tax breaks under the new act actually count against taxpayers under AMT. In addition, some tax breaks currently protected from AMT, such as some education credits and the dependent care credit, are scheduled to expire at the end of 2001 unless Congress extends the protection.

The new law provides modest relief specifically for AMT. Starting in tax year 2001, it raises the amount of income that is exempt from AMT—for example, from $45,000 to $49,000 for married individuals filing jointly. However, the increased exemption reverts to the old amount after 2004, and there is no exemption increase for estates or trusts.

As a taxpayer, your first step—especially while there is still time left in the tax year—is to assess your vulnerability to the alternative minimum tax. If you are vulnerable, several strategies may help you reduce that liability, though you may want to obtain professional advice before taking action, because AMT is tricky. For example, a typical strategy for regular income tax planning is to postpone income and accelerate expenses in order to reduce taxes in a particular year. But if you are going to have an AMT liability, you want to do the opposite, particularly if those deductions are preference items. It’s better to expose as much income as possible at the 26 and 28 percent rates, rather than at potentially higher regular rates on that income the following year.

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September 2001 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community.