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Alternative Minimum Tax

Alternative minimum tax (AMT) rules were originally designed to ensure that high-income individuals who take advantage of multiple tax breaks will owe tax each year. In recent years, however, middle-income taxpayers are likely to owe the AMT. Here's an overview of how the AMT works and possible ways to minimize it.

AMT is an alternate set of tax rules that are similar to the regular federal income tax system. But there are key differences. Under the AMT rules, certain types of income that are tax-free under the regular federal income tax system are taxable. The AMT rules also disallow certain deductions and credits that are allowed under the regular federal income tax system. And the maximum AMT rate is only 28% compared to the 39.6% maximum rate that applies under the regular federal income tax system. In addition, taxpayers are allowed a relatively large inflation-adjusted AMT exemption, which is deducted when you calculate AMT income. Unfortunately, the exemption is phased out when your AMT income surpasses certain levels.

If your AMT liability exceeds your regular federal income tax liability for the tax year, you must pay the higher AMT amount.

But taxpayers are generally more at risk if they have:

Substantial (but not necessarily huge) salary income (more than $250,000 per year).

Significant long-term capital gains and/or dividends.

Large deductions for state and local income and property taxes.

A spouse and several children (e.g., at least four) who provide personal and dependent exemption deductions for regular federal income tax purposes. (These deductions are disallowed under the AMT rules.)

Significant miscellaneous itemized deductions, such as investment expenses, fees for tax advice and unreimbursed employee business expenses.

Interest from private activity bonds. This income is tax-free for regular federal income tax purposes, but it's taxable under the AMT rules.

Significant depreciation write-offs for personal property assets, such as machinery, equipment, computers, furniture, and fixtures from your own business or from investments in S corporations, LLCs or partnerships. These assets must be depreciated over longer periods under the AMT rules.

Another noteworthy factor that's likely to trigger the AMT is exercising in-the-money incentive stock options (ISOs) during the tax year. The so-called "bargain element" — the difference between the market value of the shares on the exercise date and the exercise price — doesn't count as income under regular federal income tax rules, but it counts as income under the AMT rules. A significant spread between a stock's current market value and an ISO's exercise price can result in an unexpected AMT liability.