AMT Planning in General

IRS Statistics Show the Alternative Minimum Tax Decreasing – What Gives?

Saturday, January 14th, 2012 | Print This Post | Email This Post

Periodically the IRS publishes what it calls its Statistics of Income Bulletin. This document reports data that has been compiled from all of the tax returns filed for the previous year, including data on the Alternative Minimum Tax. This year’s report shows that, for the first time after six straight years of the AMT increasing, the amount of AMT paid and the number of taxpayers paying it decreased from the previous year. Are we finally seeing some needed relief from this burden? Hardly; rather it is just another result of the terrible economy we find ourselves in.

Fall 2011 SOI Bulletin

The Fall 2011 Bulletin includes statistics for tax returns filed in 2010 for the tax year 2009. For this period a total of 142.5 million individual income tax returns were filed, 3.8 million of which were Alternative Minimum Tax payers paying a total of $22.6 billion of AMT. These figures represent a decline from the previous year, during which 3.9 million individuals paid the AMT in the total amount of $25.7 billion. For tax year 2009 the average AMT paid was $5,900, compared to $6,500 for the previous year.

Who are the AMT payers?

The Bulletin breaks down the makeup of AMT payers by level of adjusted gross income (AGI). Even with the decline, this data shows that the distribution stayed essentially the same as the prior year, with 24% of AMT payers being those in the $100-200,000 AGI range and the majority – 63% – being in the $200-500,000 range. So many of those well below what President Obama considers “the rich” are stuck paying this tax that originally was designed to hit only the true wealthy.

Why did the AMT burden drop?

The explanation for the decrease in number of AMT payers and total dollars of Alternative Minimum Tax paid is not the result of any change in our government’s tax policy, unfortunately, but rather is explained simply by the current economic downturn. Specifically, as incomes decrease individuals are having less of those items that trigger the AMT. This applies both on the deduction side of the Alternative Minimum Tax as well as on the income side.

- Itemized deductions, in particular the deduction for state and local taxes

The amount of itemized deductions taken by individuals decreased from 2008 to 2009. The one most important to Alternative Minimum Tax payers, the deduction for state and local income taxes and property taxes, itself decreased 7.5 percent. As all AMT payers know, the more state and local taxes paid, the greater the Alternative Minimum Tax burden. It follows logically, therefore, that lower taxes paid potentially means a lower AMT burden. This won’t necessarily apply to all taxpayers, particularly those whose state legislators saw fit to increase taxes such as Illinois, but in general this result follows.

- Capital gains and dividend income

Capital gains and dividends are taxed at the same low rate both for the Regular Tax as well as the Alternative Minimum Tax. However, the more of these items a taxpayer has the more the taxpayer’s AMT exemption will be phased out and the correspondingly higher his Alternative Minimum Tax burden will be. It follows, therefore, that the worse the stock market does, and the more that companies cut back on their dividends, the less that individuals will see this impact on their AMT exemptions. Again, this won’t necessarily apply across the board, but it generally explains the result.

What should AMT payers do?

Planning to minimize the Alternative Minimum Tax is the same regardless of any changes in a taxpayer’s individual position. If an individual was on the cusp and the current state of the economy dropped him out of the AMT, there are opportunities to time some of his income and deductions to take advantage of this. For example, folks not in the AMT may want to accelerate the deduction of property taxes to take advantage of the opportunity to get a Regular Tax benefit that is not available once back in the AMT. But caution needs to be exercised as a slight change in facts can throw the individual right back into the AMT again. So planning still is, and always will be, the key.

As taxpayers get ready to undertake preparation of their 2011 taxes, this information will be very useful in thinking about 2012 planning. Certainly the 3.8 million still stuck in the AMT need to do this, as well as the 100,000 that dropped out of the AMT last year.

Posted in AMT Exemption, AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes | No Comments »

Year-End Tax Planning – Should You Accelerate or Defer Income to Minimize Your Alternative Minimum Tax?

Saturday, November 19th, 2011 | Print This Post | Email This Post

In connection with year-end tax planning, much has been written about accelerating or deferring deductions. The sometimes-overlooked question of accelerating or deferring income deserves just as much attention, especially for those in the Alternative Minimum Tax. This article will look at what needs to be considered in planning around income recognition, including a summary of the different types of income to which this planning can apply.

What happens with the AMT calculation when one’s income level changes?

Tax brackets for the Alternative Minimum Tax are progressive, as are those of the Regular Tax. What this means in simple terms is that additional amounts of income are taxed at a higher rate than the tax rates that apply to the lower levels of income. The Regular Tax has six brackets, ranging from 10% to 35%, while the AMT has just two – 26% and 28%. As will be explained below, however, there are other adjustments in computing taxable income that actually can make these stated tax brackets significantly higher.

What are the real AMT brackets?

In calculating the Alternative Minimum Tax, an individual is allowed to subtract an exemption amount from what otherwise would be taxable income. This exemption amount is $74,450 for a married couple in 2011. As has been discussed in previous articles, however, the exemption is phased out as a taxpayer’s income increases. This phaseout has the direct effect, therefore, of increasing the effective AMT tax rates for individuals who find themselves in this phaseout range.

For 2011, for the married couple, the phaseout begins at $150,000 and doesn’t stop until their income exceeds $440,000. Within this range, each incremental $100 of income will result in a loss of $25 of the AMT exemption. The result is that a 28% Alternative Minimum Tax bracket is increased by a factor of 25%, resulting in an effective AMT tax bracket of 35%!

What does all this mean for planning?

Knowing one’s effective tax bracket is the only way to do proper AMT planning. It can be a costly mistake to deliberately accelerating income, thinking one is in an Alternative Minimum Tax bracket lower than the Regular Tax bracket, only to find out this actually is not the case. Many year-end tax planning articles routinely suggest that people in the AMT do exactly this, but without knowing what your effective AMT tax rate is it could instead turn out to be a costly mistake.

What types of income can be accelerated or deferred?

The answer to this question will depend on each individual’s situation- i.e., whether the person is employed or self-employed, what kind of investments the person has, etc. Discussed below is a brief overview of some of the types of income that an individual may be able to accelerate or defer at year-end.

- Employee compensation such as bonuses and stock options

Some employers allow employees the choice of taking their bonuses currently or deferring them to a future year. In addition, employees may be granted stock options, and the timing of when these options are exercised is entirely up to the employee – they can be exercised just as easily in December as they can in January. If the employee has what are known as nonqualified stock options, taxable income will be recognized immediately on the date of exercise – both for the AMT as well as Regular Tax purposes. If the options are qualified options (these are more commonly known as incentive stock options, or ISOs), there is no taxable income on the date of exercise for Regular Tax purposes, but there is for the Alternative Minimum Tax.

- Business income from self-employment, LLCs or partnerships

A business usually has some degree of control at year-end over its net income for that last month of the tax year. For example, a cash-method business could pay outstanding bills in December to reduce income, or wait to pay them in January, which would directly affect the amount of income reported on the business owner’s tax return. The business also could hold off from sending out certain bills out towards the end of the year, thus postponing income into the following year.

- Investment income

Here are some acceleration or deferral thoughts on a few types of investments:

Capital gains – an individual has complete control over the timing of any sales of investments, so capital gains easily could be recognized this year or next.

Rental income – a landlord might ask for the rent check that is due on January 1^st to be paid a few days early.

Interest and dividends – as a longer-term strategy, an individual could shift in or out of bonds and/or dividend-paying stocks to affect the amount of interest and dividend income received on a current basis.

Conclusion

Knowing what tax bracket the taxpayer is in is critical to any tax planning, but especially so for individuals in the Alternative Minimum Tax. The only way to minimize the AMT is to take a little time as we approach year-end to look at the options available in terms of what income might be moved between 2011 and 2012, and then to figure out which of these choices will result in the lowest tax burden. With the holiday season keeping everybody pretty busy, it’s never too soon to start doing at this!

Posted in AMT Exemption, AMT Items, AMT Planning in General, Calculation of the AMT, Capital gains & Dividends, Incentive Stock Options Exercised, Investor, Self Employed, Type of Taxpayer | No Comments »

Year-end Tax Planning Newsletter Focusing on the Alternative Minimum Tax – October

Saturday, November 12th, 2011 | Print This Post | Email This Post

Oct2011-Newsletter

Posted in AMT Exemption, AMT Planning in General, Calculation of the AMT | No Comments »

IRS Releases 2011 Version of Form 6251 – Alternative Minimum Tax-Individuals, a Reminder That It’s Time to Start Thinking about Year-End Tax Planning

Saturday, September 24th, 2011 | Print This Post | Email This Post

The IRS recently released its 2011 version of the Form 6251 – Alternative Minimum Tax – Individuals. With year-end only a few months away, this serves as a timely reminder that anyone stuck in the AMT needs to start thinking about the ways they can reduce this burden. The most effective AMT planning strategies must be implemented by December 31 in order to have any impact on the current year’s taxes. This article provides a general overview of some of the more important of these planning strategies.

AMT exemption amount

Late last year Congress once again adjusted the AMT exemption amount for inflation - for 2011 it is $74,450 for married couples filing a joint income tax return and $48,450 for singles. While Congress hasn’t even started thinking about the “patch” that will be needed again on January 1, 2012, we can guess that at some point that will be taken care of.

Phaseout of the exemption

For taxpayers whose incomes reach a certain level, the exemption is gradually phased out. This phaseout is at the rate of $1 of exemption lost for every $4 of income above the threshold. For 2011 the threshold for marrieds filing jointly is $150,000, and for singles it is $112,500. If a couple’s income is $160,000, for example, the exemption is reduced by $2,500. If the couple’s taxable income reaches $447,800, the exemption is zero.

Capital gains and dividends

While capital losses may be more typical these days due to the stock market’s wild gyrations, it’s important to note the AMT impact that results from capital gains as well as dividend income. These sources of income are taxed at the same 15% rate for both the AMT as well as the Regular Tax, but there is a direct impact on an individual’s AMT burden because of the exemption phaseout discussed above. For example, a $10,000 capital gain by itself can result in $700 of AMT being paid (loss of $2,500 of exemption times the marginal AMT rate of 28%).

Itemized deductions – state and local income taxes

The one item that affects the greatest majority of folks stuck in the Alternative Minimum Tax is the itemized deduction for state and local income taxes. While allowable for the Regular Tax, this deduction is disallowed in its entirely for the AMT. For taxpayers who expect to be in the AMT for 2011, serious consideration should be given to postponing payment of some portion of these taxes into 2012. If the taxpayer is not in the AMT in 2012, real tax dollars can be saved that otherwise would have been “wasted” by not ding this basic planning.

Itemized deductions – property taxes

The next biggest item in terms of AMT exposure is property taxes which, similar to state and local income taxes, are not deductible in computing the Alternative Minimum Tax. Many taxpayers receive their property tax bills in the fall, with a period of months before the taxes are actually due. Just as with the state income tax planning mentioned above, taxpayers currently in the AMT might be better off pushing the payment of these property taxes into 2012.

Other AMT items

There are quite a few other AMT items in addition to those mentioned above. Some of these items are deductions from income that are allowed for Regular Tax purposes but not allowed for the AMT, while others are certain types of income that are treated differently for the Alternative Minimum Tax. The Form 6251, available on the IRS’ web site, serves as a list of all of these items. Taking a look at last year’s tax return serves as a great starting point to see which items are likely to affect the taxpayer again this year.

The value of planning

The average amount of AMT paid by each taxpayer caught in its tentacles is over $5,000. Just a little bit of time spent on basic tax planning can result in some significant amounts being saved!

Posted in AMT Exemption, AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes, Uncategorized | No Comments »

Incorporate Your Small Business and Avoid the Alternative Minimum Tax

Saturday, July 30th, 2011 | Print This Post | Email This Post

The Alternative Minimum Tax applies both to corporations as well as to individuals. While many of the AMT rules are the same, there are some significant differences between the two. One of the more significant of these differences is a provision that totally exempts Small Business Corporations from the AMT. This can present real tax savings opportunities for individuals who are paying the Alternative Minimum Tax because of their business activities.

Small Business Corporation

A Small Business Corporation is an entity formed under state corporate law that has not made an election to be taxed as an “S” corporation. An S corporation does not pay tax itself; rather the income and losses – and AMT items – of the entity “pass through” to the corporation’s shareholders and are reported on the Forms 6251 attached to their individual Forms 1040. A “regular” corporation – including a Small Business Corporation – is separate from its owners, filing its own tax returns and paying its own taxes.

It should be noted that businesses that are formed and operated as sole proprietorships, partnerships or limited liability companies (LLCs) also pass through their income, losses and AMT items to the underlying owners just as S corporations do.

New business vs. existing business

A start-up business has total freedom to choose whatever form it wishes to operate in. Existing businesses currently operating in one of the pass-through forms may want to re-form themselves as Small Business Corporations to take advantage of this AMT benefit. While an S corporation may simply revoke its S election, for the other entities there are certain administrative costs associated with creating a new form of business that will need to be taken into consideration.

Total exemption from the AMT for a Small Business Corporation

In general the AMT applies to all corporations, just as it does to all individuals. However, Congress decided that smaller businesses operating in the corporate form should be totally exempt from the AMT. The test to qualify for this exemption is simple, and it is based on the gross receipts of the business.

If a small corporation has gross receipts of $5 million or less per year it qualifies as a Small Business Corporation, and, thus, it also qualifies for the AMT exemption. The actual test is the average of the entity’s gross receipts over a three-year period. Once a corporation initially qualifies as a Small Business Corporation under the $5 million test, in subsequent years it is allowed to have average gross receipts of up to $7.5 million while still retaining its qualification.

AMT items resulting from operating a business

This exemption from the Alternative Minimum Tax applies only to AMT items that result from operating a business. It does not apply, for example, to nonbusiness AMT items such as the adjustments needed for an individual’s itemized deductions like state and local taxes, home mortgage interest, medical and dental, etc., as well as things like incentive stock options.

The following are the AMT items associated with operating a business:

- depreciation, and corresponding adjustments on disposition of business property

- net operating losses

- depletion, intangible drilling costs and mining costs

- R&D expenses

- long-term contracts

- circulation costs

Other tax issues to be considered

There are a number of non-AMT tax benefits resulting from operating a business in a pass-through entity that also need to be taken into consideration when evaluating the Small Business Corporation benefit. For example, if a pass-through business has start-up losses, these losses may be deductible on the business owner’s personal tax return. For a regular corporation, such losses are accumulated and may be used as a deduction only against future income of the corporation.

If the business is profitable, there is a possibility that the profits from a regular corporation effectively could be taxed twice unless proper planning is done. With the corporation itself paying taxes on its income (after deducting any prior year losses), if it pays a dividend to its shareholders those profits would be taxed twice. This problem can be avoided if the business owners are paid salaries, which are deductible by the corporation, thus avoiding this double tax issue.

Planning to take advantage of this AMT exemption

The key for any taxpayer considering taking advantage of this total exemption from the Alternative Minimum Tax is to start by looking at how much AMT is being paid as a result of the above-listed business AMT items. Only if the total is material enough to offset the costs of changing the form of business, and only if the other tax issues mentioned above do not present negatives, should incorporation be considered.

Conclusion

As has been discussed in previous articles, each AMT item presents its own individual planning opportunities. For the items that result from operating a business, a taxpayer needs to go through each and every one of them to consider the effects of the choices and tax elections he has. As an alternative to this by-the-ones approach, having the business operating in a qualifying Small Business Corporation completely eliminates the need to do this, and might even result in totally avoiding the Alternative Minimum Tax!

Posted in AMT Planning in General, Depreciation & Disposition of Property, Self Employed, Type of Taxpayer | No Comments »

States That Have Their Own Alternative Minimum Tax – Double the Worry for Federal AMT Payers, but Double the Benefit from Proper Tax Planning

Monday, July 11th, 2011 | Print This Post | Email This Post

Most states impose an income tax at the state level, separate and distinct from the Federal income tax. A number of these states also have their own version of an Alternative Minimum Tax – one that is imposed at the state level, separate and distinct from the Federal Alternative Minimum Tax. While a state AMT certainly adds to the burden of those subject to the Federal Alternative Minimum Tax, the proper implementation of tax planning opportunities in these situations can result in a double benefit to the taxpayer.

Federal AMT calculation

Many of the itemized deductions that are taken for the Regular Tax on an individual’s Form 1040 are adjustments that directly trigger the Federal AMT. Chief among these is the deduction for state taxes, the biggest part of which is state income taxes. The consequences of high state income taxes are easy to see – the more state income tax paid the more AMT that will be paid at the Federal level. This is why individuals in high income tax states such as New York and California are among the leaders in Federal AMT paid.

States with an AMT

Speaking of New York and California, these are the two leading jurisdictions with a state level Alternative Minimum Tax. This is on top of these states’ Regular income tax rates, which already are among the highest in the nation. For example, the highest marginal Regular Tax rate for New York (not even including New York City) is 8.97 percent, and for California it is 9.3 percent (10.3 percent for those making over $1 million). As if these weren’t high enough, taxpayers with AMT items will end up paying tax rates effectively even higher than these.

Computation of the state Alternative Minimum Tax

Not surprisingly, both California and New York structure their own AMT by following, at least in part, the Federal rules with regard to AMT items as shown on Form 6251. Thus, for example, if a taxpayer in one of these states has an AMT item resulting from depreciation, depletion, intangible drilling costs or small business stock, these will also factor into computing the state Alternative Minimum Tax. But each also state has its differences from Federal, so an AMT payer must be careful to take note of these differences. For example, private activity bond interest is reported in computing New York’s but not California’s. To the contrary, AMT adjustments for itemized deductions are reported in California but not New York.

Planning to reduce the state AMT

To the extent a Federal AMT item also affects an individual’s state AMT, the tax planning strategy is the same for both. For example, an election to use straight-line depreciation instead of accelerated depreciation on property used in a business or held for investment will reduce the Alternative Minimum Tax both at the state as well as at the Federal level. In California, where itemized deductions trigger the AMT, careful planning for the timing of the payment of real estate taxes can reduce the California AMT as well as the Federal. Note also that California picks up the Federal adjustment for Incentive Stock Options (ISOs), so proper planning for these can in many cases result in the taxpayer’s totally avoiding paying the Alternative Minimum Tax.

Effect of planning on the combined Federal and state AMT burden

The added significance to AMT planning for individuals in jurisdictions with a state AMT is the compounded savings that can be achieved. For example, the highest Federal AMT rate is 28 percent, and the California AMT rate is 7.25 percent, while in New York the AMT rate is 6 percent (plus another 2.85 percent for New York City residents). Therefore, moving an AMT item from a year the taxpayer is stuck in the AMT to a year the individual is paying the Regular Tax could have a tax savings benefit of over 35 percent.

Conclusion

Of the four million individuals paying the Federal AMT, a significant number live in states that also have a state level Alternative Minimum Tax. AMT planning in general always will yield tax savings; for individuals living in these AMT states the planning is even more valuable in terms of actual tax dollars that can be saved.

Posted in AMT Planning in General, Calculation of the AMT, States with an AMT | No Comments »

Tax Court Denies Challenge to the Alternative Minimum Tax, Revealing Costly AMT Taxpayer Errors

Sunday, May 15th, 2011 | Print This Post | Email This Post

On occasion a frustrated taxpayer will go to Tax Court in an attempt to convince a judge that the Alternative Minimum Tax was never intended to apply to them. As in the case of Fritz v. Commissioner, however, no sympathy is ever found there – if the calculations are done correctly the Court simply confirms that the tax is owed. The facts in these cases present interesting lessons, however, because they reveal both the terrible feeling of frustration when getting blindsided by the AMT as well as the simple, yet missed, planning opportunities that could have allowed many of these folks to avoid paying the AMT.

Facts of the case

Mr. and Mrs. Fritz filed their tax return without attaching Form 6251, “Alternative Minimum Tax – Individuals.” They promptly received a notice from the IRS informing them that they owed exactly $7,007 more in AMT. The Fritz’s tax return was relatively simple – $329,000 of total income, the majority of which – $283,000 – was long-term capital gain and qualifying dividends. The Fritzes took the standard deduction, apparently because this was greater than their itemized deductions, as well as the deduction for their personal exemptions.

Alternative Minimum Tax problem

Two AMT issues caused the Fritz’s Alternative Minimum Tax problem.

Loss of the standard deduction and the deduction for personal exemptions

As has been discussed in many previous articles, under the AMT the standard deduction is disallowed in total, as are the deductions for personal exemptions. Because of this, Alternative Minimum Taxable Income (AMTI) is always higher than Regular Tax taxable income by these amounts. For 2011, the standard deduction for a married couple filing jointly is $11,600, and each personal exemption is $3,700. In a case like the Fritzes, their AMTI for the current year would be $19,000 higher.

Loss of the AMT Exemption due to the large capital gain

When a married couple’s AMTI exceeds $150,000 the AMT exemption begins to be phased out. The exemption amount for 2011 is $74,450, but this is phased out at the rate of $1 of exemption for every $4 of AMTI in excess of $150,000. In the Fritz’ situation, they would lose $44,672 allowing them an AMT exemption amount of only $29,778.

The Fritz’ argument

The argument made to the Tax Court by the Fritzes was that capital gains and qualifying dividends should be taxed at the 15 percent tax rate, as specified in the tax law for both the AMT as well as for the Regular Tax. By operation of the AMT calculations, they alleged, their effective tax rate on this income actually was higher than this.

The Tax Court’s answer

The Tax Court judge was direct in his response: “Petitioner’s position in this case misses the point. In reality, the tax on the capital gains was limited to 15 percent and the ‘additional tax’ was attributable to the elimination of preferences.” Judgment in favor of the IRS.

Planning opportunities the Fritzes missed

There are several things the Fritzes could have done to reduce, and likely eliminate, their Alternative Minimum Tax.

Itemizing deductions instead of taking the standard deduction – If the Fritzes had home mortgage interest, or if they had made any charitable contributions, they could have reduced their AMT by itemizing deductions instead of taking the standard deduction. This, unfortunately, is a common error for AMT payers. If they had had, for example, just $1,000 in interest or contributions, they would have directly reduced their Alternative Minimum Tax by $280. They weren’t required to take the standard deduction; they did it because it was larger than their itemized deductions, and they just didn’t think about the AMT.

Spread the capital gain over two or more years – The timing of when to sell securities and realize capital gains is entirely within the control of a taxpayer. Not spreading their very large gain of $246,000 over just two years was a costly mistake on the part of the Fritzes. If they had instead recognized half of their capital gain in the current year and pushed the other half to the following year, they would have lost over $30,000 less of their AMT exemption, most likely removing them entirely from the AMT!

Conclusion

As the Fritzes learned the hard way, paying the Alternative Minimum Tax is a penalty that often can be avoided with just a little awareness of the AMT. Had Mr. & Mrs. Fritz done this, they would have $7,000 more in their bank account today instead of having to put this amount in the mail to the US Treasury. Lesson learned the hard way!

Posted in AMT Exemption, AMT Planning in General, Calculation of the AMT, Capital gains & Dividends, Personal Exemptions, Standard Deduction | No Comments »

401(k) Roth Conversion: Alternative Minimum Tax Payers Need to Give this Serious Consideration

Saturday, April 16th, 2011 | Print This Post | Email This Post

Recent tax law changes have opened up a whole new area of tax planning around employee retirement plans. Individuals with IRA accounts always have had the opportunity to do a Roth conversion, but now for the first time an employee’s 401(k) account also may be converted. Because a 401(k) typically will have a much larger balance than an IRA, this tax opportunity deserves serious consideration, particularly for individuals who currently are in the Alternative Minimum Tax.

Background

This past September the Small Business Jobs Act of 2010 was signed into law. One of the provisions in this act allowed, for the first time, a “regular” 401(k) to be converted to a Roth 401(k). The sponsoring employer first must make the appropriate plan amendments to allow this, but because of the popularity of this provision it is estimated that over half of all employers already have made this change.

What happens upon conversion?

The dollars an employee contributes to a regular 401(k) are pre-tax. What this means is that income taxes have not yet been paid on these contributions; instead, when distributions are taken from the plan, typically at retirement, taxes are paid at that point. Along with the original contributions, the investment earnings in the 401(k) likewise are taxable when withdrawn. In contrast, a Roth is funded with after-tax dollars, so, correspondingly, there are no taxes due at the time the funds are withdrawn. Similarly, the earnings on these funds are not taxed at distribution.

At the time of conversion from a regular 401(k) to a Roth, income taxes must be paid on the full amount converted. With this prepayment of taxes, and the 401(k) now officially a Roth, no taxes are due when distributions are made.

Example

Assume over the years you have put $100,000 into your regular 401(k), and the cumulative investment earnings are $50,000. If you did a Roth conversion today, assuming you are in the 33% Federal bracket (Regular Tax; not the AMT), along with a state tax rate of 6%, you would pay $58,500 in taxes, leaving $91,500 for your retirement spending.

Compare this to an account that was a Roth 401(k) right from the start. Since you would have paid the 33% and 6% taxes before the monies went into the account, you would have contributed only $61,000 ($100,000 less $39,000 in taxes). Earnings on this at the same rate of growth as in the example above would have been $30,500, for a grand total in the account of $91,500.

The point

As was seen in the example above, there is one single most critical point in making a Roth conversion analysis: the comparison between the taxpayer’s current tax bracket and the tax bracket he or she expects to be in at retirement. How does one go about making this comparison?

Tax brackets – assuming no changes

On the IRS web site one can see that, assuming married filing jointly status, the Regular Tax 28% bracket is reached at $83,600 of taxable income, the 33% bracket at $174,400, and the 35% bracket at $379,150. Compare this to the AMT bracket of 26% for Alternative Minimum Taxable Income up to $175K, and 28% for everything over that level. Ignoring for purposes of simplicity the fact that taxable income is not computed the same for the AMT as it is for the Regular Tax, looking at these brackets reveals something very interesting: AMT brackets are significantly lower at roughly comparable levels of income.

This fact alone is the reason individuals currently in the AMT definitely need to give serious consideration to doing a Roth conversion. The potential for a 7% savings from differences in the tax brackets (28% vs. 35%, e.g.), or even more, definitely is there.

Tax brackets – there will be change

Making things a little more difficult, however, is the fact that tax brackets will change. Someday the Democrats will get their way and the Bush tax cuts will be allowed to expire. When this happens, Regular Tax rates will increase, and it will appear even more attractive to do a Roth conversion today. Keep in mind, however, that one of the other likely changes in tax brackets simply will be the individual taxpayer’s level of income. For most folks, income in retirement will be less than what it is while they are working, and, thus, that person’s tax bracket will decrease. To what extent this will or will not offset the anticipated increase in the brackets from the law changing is up to each individual to decide.

Conclusion

The recent change in the tax law allowing Roth conversions presents every individual with a 401(k) a real opportunity to save taxes. This opportunity is much greater for taxpayers who currently are paying the Alternative Minimum Tax than it is for those who are not. A little time spent making a Roth conversion analysis easily could result in thousands of dollars in tax savings.

Posted in AMT Planning in General, Calculation of the AMT, Retiree, Salaried, Type of Taxpayer | No Comments »

Exercising Employee Stock Options – Beware of the Alternative Minimum Tax

Saturday, April 2nd, 2011 | Print This Post | Email This Post

With the stock market having nearly doubled over the past two years, many individuals holding stock options that they received from their employers are giving serious consideration to cashing out the value in these options. This article discusses the two principal types of options and explains the different AMT issues associated with each.

Types of stock options

For tax purposes there are two types of stock options – “qualified” and “nonqualified.” The official term for a qualified option is Incentive Stock Option, commonly referred to as an “ISO.” Each employer has the discretion, through the design of its plan, as to which type of option it grants to the employee, and it is not uncommon for some employees to have both types. It is important to note here that it is the responsibility of the individual to understand what he has.

Stock option essentials

A stock option, like any other option, is a contract giving one person the right to buy property from another person at a predetermined price. If the underlying property (stock) increases in value, the value of the option correspondingly increases. If the value of the stock decreases, the option has no value. Options generally have a fixed term – five to ten years for stock options is common, so the employee must act within this period or the option will lapse.

Example – an employee is granted an option to buy 1,000 shares of his employer’s stock at today’s value of $50. If the stock increases to $60 before the option lapses, the employee can exercise the option, effectively buying the shares from the employer at a discount and, in this example, realizing a $10,000 gain. To alleviate the hardship of asking the employee to write a check for the $50,000 exercise price, employers commonly arrange with a broker to allow what is referred to as a “cashless” exercise involving a same day sale. In this situation, on the date of exercise the broker sells an equivalent number of shares, and then sends the employer the $50,000 along with enough to cover the tax withholding requirements. Then, at the close of the market’s three-day settlement period, the net amount ($10,000 less taxes) is credited to the employee’s account.

Tax results from option exercise

Nonqualified option – on the date of exercise the $10,000 in the above example is taxable income. This is ordinary income, not capital gain, just as if it were part of the employee’s salaries and wages. The $10,000 will be included in taxable income reported in the employee’s W-2 at the end of the year.

ISO (qualified option) – The $10,000 will not be taxed as income on the date of exercise. Instead, it is a tax preference item for purposes of the AMT, meaning that Alternative Minimum Taxable Income will be higher than the employee’s Regular Tax taxable income by $10,000. The number in this example is relatively small, but if the preference item from an ISO exercise is large enough the employee easily can find himself stuck in the AMT. If the individual already is in the AMT, the hit from an ISO exercise will make it just that much more painful.

Tax planning for option exercises

The exercise of a nonqualified option does not have any direct AMT consequences. As an individual’s taxable income increases, however, the Alternative Minimum Tax exemption is phased out, so testing for the impact of this is important before exercising even a nonqualified option.

Especially critical, however, is tax planning before doing an ISO exercise. In order to exercise an ISO without triggering the Alternative Minimum Tax, the individual has to do the tax calculation under alternative assumptions as to the size of the exercise, as well as consider doing the exercise partially in one year and partially in the next. By doing this it certainly is possible to minimize the impact of an ISO exercise. Note also that the employee has a period of time after the exercise within which a sale of the stock will constitute a “disqualifying disposition,” thus negating the AMT effect and retroactively treating the transaction as if it were instead a nonqualifying option.

Summary

The underlying investment decision as to the right time to cash out of employee stock options must, of course, must be the individual’s primary focus, but if that exercise will bring along with it a big AMT hit taxes need to be considered in deciding how many options to exercise and in what year they are exercised. That nice chunk of extra income the employee thinks he is getting can be seriously eroded by improper tax planning.

Posted in AMT Exemption, AMT Planning in General, Incentive Stock Options Exercised, Salaried, Type of Taxpayer | No Comments »

I Am Retired – Does the AMT Apply to Me?

Thursday, March 17th, 2011 | Print This Post | Email This Post

Of all the different types of AMT taxpayers, retirees typically are the most surprised when they find themselves stuck in the Alternative Minimum Tax. Unfortunately, there is no “age exemption” for the AMT – an individual could reach 100 and still be paying it, depending on that person’s level and types of income and tax deductions. In certain cases, the AMT may even hit a retiree harder than a person still working. With a little understanding of the issues and some advance planning, retirees may actually be in a better position than others to do something about the AMT.

There’s a great story that Eric Solomon, Assistant Secretary of the U.S. Treasury for Tax Policy during the Bush administration, used to tell. His father had received a letter from the IRS stating that his 2004 tax return could not be processed because he had not computed his Alternative Minimum Tax. “My dad said, ‘I’m 82. I don’t pay the AMT,’” Solomon would recall. Unfortunately, no such octogenarian exemption exists, but Solomon said he had to spend three hours on the phone with his dad working through the Form 6251.

This article will address both income issues associated with retirees and the AMT as well as deduction issues.

Income issues

Retirement plan distributions

Individuals have many choices as to how they can take distributions from their retirement plans, whether these plans are in the form of pensions or 401(k)-type plans. A lump-sum distribution, or some other accelerated form of distribution, more likely would trigger the AMT than choosing a lifetime annuity. This is because the higher one’s income is in any one year the more likely the AMT exemption is phased out, in turn meaning the more likely the individual is to be in the Alternative Minimum Tax.

Stock options- nonqualified

Many mid- to upper-level employees who work for a corporation, typically a publicly-traded corporation, receive “nonqualified” stock options as part of their compensation packages. Many of these option plans allow the individual a certain period of time after retirement to exercise these options. Similar to the point made above with respect to retirement plans, a retiree must consider the AMT impact when deciding when to exercise these options and how much income will be generated.

Stock options – Incentive Stock Options

If an individual has Incentive Stock Options, the exercise of these in one year can almost guarantee paying the Alternative Minimum Tax. This is because the difference between the value of the stock on the date of exercise and the option price is a direct AMT preference item – unlike the indirect effect the exercise of nonqualified stock options can have as discussed above.

Capital gains

Retirees on occasion may have capital gains that are disproportionately large in comparison to the rest of their income. These gains may result from distributions from mutual funds, over which the individual has no direct control, or from an effort to diversify an investment that is too concentrated in one stock, or from any number of reasons. These sudden bumps in income can cause the retiree to lose a portion of his AMT exemption, resulting in a problem similar to those discussed above.

Deduction issues

Standard deduction

A taxpayer may elect to take the “standard deduction” in lieu of itemizing deductions. The amount of the deduction varies by filing status, but for a couple filing jointly it is $11,600 for 2011. Since no standard deduction is allowed for the AMT, Alternative Minimum Taxable income – the amount on which the AMT is calculated – will be $11,600 higher than Regular Tax taxable income. Add to this the extra $2,300 exemption for folks age 65 and over and one can see why more and more retirees are being pulled into the AMT. Note that an extra amount also is allowed in cases of blindness, further exacerbating the problem for these individuals.

Property taxes and state income taxes – changes in state of residence

An individual who itemizes deductions generally will get a Regular Tax benefit for property taxes and state income taxes, as well as certain other state and local taxes. None of these taxes is allowable as a deduction in computing the Alternative Minimum Tax. Accordingly, like the standard deduction issue discussed above, taxable income on which the AMT is calculated will be higher than Regular Tax taxable income. If a change in state of residence at retirement is contemplated, it is important to plan for the AMT effects. Moving from a high state and local tax jurisdiction to a state without income tax like Florida, for example, could mean falling out of the AMT along with a corresponding opportunity to move income, or deductions, from one year to the other to minimize the AMT.

Summary

A sudden change in one’s income position, as typically happens in the case of retirement, can present significant Alternative Minimum Tax planning opportunities. Deductions that would be lost in an AMT year may be shifted to a Regular Tax year, and income might be taxed at a lower rate in one year versus the other. These principles apply to all future retirement years; not just the year of transition from employment to retirement. While often overlooked, taxes, especially the Alternative Minimum Tax, are a very important part of planning for retirement.

Posted in AMT Exemption, AMT Planning in General, Calculation of the AMT, Capital gains & Dividends, Incentive Stock Options Exercised, Retiree, Standard Deduction, State Income & Other Taxes, Type of Taxpayer | 1 Comment »