Beating the Retiree Tax Surprise

The granddaddy of all the stealth taxes continues to thrive, snaring more taxpayers each year. Though designed to hit only the wealthiest taxpayers, it now is imposed on many others, and its prime payers often are those in or near retirement.

The Alternative Minimum Tax (AMT) essentially is a second tax system. You compute your regular income tax and your AMT and pay the highest of the two.

The AMT is in some ways a flat rate tax system. You start with your regular income tax computation, and then you back out certain tax breaks called tax preferences. You apply an exemption of $80,800 for married couples filing jointly and $51,900 for single taxpayers. The result is AMT taxable income, which is taxed at only two rates: 26% and a maximum rate of 28%. But the exemption phases out for incomes starting at $156,500 for marrieds filing jointly and $117,300 for singles. That gives the taxpayer a 35% marginal rate during the phaseout range.

Under the AMT you’re allowed the itemized deductions for charitable contributions and mortgage interest, other than most home equity mortgage interest. You’re allowed reduced deductions for some medical and dental expenses. Some business deductions are deferred, such as depreciation and net operating losses.

You’re not allowed the itemized deductions for state and local taxes and for miscellaneous expenses. You’re also disallowed under the AMT both the standard deduction and personal and dependent exemptions. Tax-exempt bond interest generally is exempt from the AMT, but interest from private-activity bonds is taxed under the AMT.

The full list of tax preferences is in the instructions for Form 6251, available free on the IRS web site at www.irs.gov.

There are several ways the AMT can be triggered for retirees and pre-retirees.

The disallowance of itemized deductions such as state and local taxes and mortgage interest plus the reduction in medical expense deductions can trigger the tax as can the disallowances of the standard deduction for those who don’t itemized and personal and dependent exemptions. All these items aren’t the exclusive province of the wealthy and can trigger the AMT for others.

Tax items that aren’t tax preferences also can interact with the AMT so that they trigger or increase the AMT. Among them are tax-favored items such as long term capital gains and qualified dividends.

When you have a high amount of capital gains and dividends, you pay a low regular income tax rate. But capital gains and dividend count as income under the AMT, so they can take you above the exemption amount just a quickly as ordinary income does. They also might incur state income taxes, which are deductible under the regular tax but not the AMT. The result of the combination is that you could owe more tax under the AMT than the regular income tax just because you earn a high percentage of your income from capital gains or qualified dividends.

The AMT now applies to eight times as many taxpayers as 20 years ago. Unfortunately, there is no formula that can warn you the AMT might be a problem, because the tax is so complex and has so many moving parts. You have to compute your tax both ways to see if the AMT is a problem.

The AMT can be triggered by taking a large capital gain one year or by having three or more dependents while living in a high tax state. For retirees, required minimum distributions from IRAs can trigger the tax as they increase over the years. Combinations of the different tax preference items or transactions that increase income can unexpectedly make you subject to the AMT. Many people are trapped in the AMT because they are subject to it on year but not another.

Any year you’ve had changes in any of the items discussed here should cause you to worry about the AMT. Estimate both the AMT and regular income tax both mid-year and close to year-end. If you might be subject to the AMT, there are steps to consider.

When disallowed deductions might trigger the AMT, consider spreading them over two tax years if you can. Otherwise, you receive no tax benefit from regular deductions if you’re hit by the AMT.

You could defer income. For example, consider spreading a large capital gain over two years instead of one if it is possible. Look for way to limit distributions from IRAs and annuities. Consider converting a traditional IRA to a Roth. This might make you subject to the AMT in the conversion year but make it less likely in future years. When the law makes the option available, make charitable contributions from a traditional IRA instead of using cash. Or give appreciated stock or other assets to a charity instead of selling the stock and giving cash.

Above all, recognize the potential for the AMT to rear its head when there’s a significant new element in your tax picture and estimate your taxes before year end so you can take action if needed. If you’ve been preparing your own taxes, a year when the AMT is a possibility is a good time to work with an experienced tax expert.

RW November 2014.