Calculation of the AMT

The Fiscal Cliff Avoided: Alternative Minimum Tax Payers Finally Get a Permanent Fix for the AMT “Patch”

Saturday, January 5th, 2013 | Print This Post | Email This Post

A most amazing thing has just happened. On the brink of 30 million additional taxpayers getting sucked into the AMT vortex for the first time, not to mention the 4 million already there each getting ready to pay thousands more in taxes, just hours after the deadline actually had passed Congress found a way to enact a permanent fix for the AMT patch. And with direction from a vacation home in Hawaii to make us of his autopen, on January 2 the President signed the Taxpayer Relief Act of 2012 into law. No longer do AMT payers have to fear the dropping of the ball in Times Square, with the negative tax implications associated with the turning of a new year. Instead, with the certainty that this new law brings, time will be better spent planning to minimize the AMT burden that folks already have.

The Patch

The annual Patch, as it has been called, is accomplished by indexing the AMT exemption amount for the annual change in the Consumer Price Index, as is already being done with many other tax law provisions. Without this fix, the 2012 exemption for a married couple would have been $45,000; with the fix it will be $78,750 for 2012. This difference would have meant nearly 30 million additional folks falling into the AMT. The 2013 exemption indexing has not yet been computed by the IRS, but it is expected to be approximately $80,800.

The cost of the permanent fix

The Congressional Joint Committee on Taxation has calculated the ten-year cost of the permanent AMT patch to be a whopping 1.8 trillion dollars. This is nearly one-half of the total cost of the changes made by the new law. Interestingly, Congress exempted itself form the standard requirement that tax breaks , as well as any spending measure for that matter, be offset by revenue raisers. But that did not have to be done here.

Other changes to the tax law affecting AMT payers

In addition to the Patch, numerous other provisions in the new law will have a direct impact on AMT payers. One of these is the subject of tax credits. A credit is a dollar-for-dollar reduction in your tax liability – i.e., a $100 tax credit will reduce your taxes by $100. A $100 deduction, on the other hand, will save you taxes to the extent of your tax bracket. For example, if an expense is AMT-deductible, and if you are in the 28% AMT bracket, a $100 deduction will reduce your taxes by $28.

Prior to these new law changes, many credits were allowable only against the Regular Tax and not against the Alternative Minimum Tax. Examples of these are the child care credit and the residential energy tax credit. Now, however, under the new law these and many other credits may be taken even by folks in the AMT. This is a real benefit.

Conclusion

What a great relief the new law brings. That being said, however, there are 4 million folks out there still paying the Alternative Minimum Tax, and there are lots of planning opportunities in existence to reduce the amount each person actually pays. With the start of a new year, it behooves every AMT payer to plan to pay less AMT in 2013 than he or she paid in 2012.

Posted in AMT credits, AMT Exemption, AMT Planning in General, Calculation of the AMT, Legislation/tax law changes | No Comments »

Year-End Tax Planning – Accelerating or Deferring Income to Minimize Your Alternative Minimum Tax

Sunday, December 2nd, 2012 | Print This Post | Email This Post

At year-end many articles are 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.

Comparing tax brackets

Tax brackets for the Alternative Minimum Tax are progressive, as are those of the Regular Tax. For 2012 the Regular Tax has six brackets, ranging from 10% to 35%, while the AMT has just two – 26% and 28%. For AMT payers, however, the stated brackets are directly affected by the AMT exemption phaseout.

For a 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%!

Knowing one’s effective tax bracket is the 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.

The types of income can be accelerated or deferred

- Employee bonuses and stock options

Employers may allow employees the choice of taking their bonuses currently or deferring them. Employees also may be granted stock options, and these can be exercised in December or in January. For nonqualified stock options, taxable income will be recognized immediately on the date of exercise – both for the AMT as well as Regular Tax purposes. For qualified options (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

A cash-method business could pay outstanding bills in December to reduce income, or wait to pay them in January, and this directly affects 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, postponing income into the following year.

- Investment income

Capital gains – an individual controls the timing of any sales of investments, so capital gains could be recognized this year or next.

Rental income – a landlord might ask that the rent that is due on January 1^st be paid in this year or next.

Interest and dividends – an individual can shift between bonds and dividend-paying stocks to affect the amount of interest and dividend income received.

Conclusion

Knowing what tax bracket you are in is critical to tax planning. An effective way to minimize the AMT is to look at the options available in terms of what income might be moved between 2012 and 2013, and then to figure out which of these choices will result in the lowest tax burden. With year-end rapidly approaching, it’s definitely time to get out the calculator!

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

Alternative Minimum Tax Payers and the Fiscal Cliff – Now is the Time to Consider a Roth Conversion

Sunday, November 18th, 2012 | Print This Post | Email This Post

Individuals with IRAs and 401(k) accounts have the opportunity to do a Roth conversion before year-end, potentially saving thousands of dollars of taxes on their retirement plans by paying taxes now and not having to pay any taxes in the future. This opportunity deserves serious consideration by all taxpayers, but particularly so for individuals who currently are in the Alternative Minimum Tax or may be in the future.

What happens upon conversion?

The dollars an employee contributes to a regular 401(k) and a regular IRA generally are pre-tax. This means that income taxes have not yet been paid on these contributions; instead, taxes are paid when distributions are taken from the plan at retirement. Along with the original contributions, the investment earnings in the plan likewise are taxable when withdrawn. In contrast to these regular plans, a Roth plan is funded with after-tax dollars, so there are no taxes due at the time the funds are withdrawn, both for the original contributions as well as the accumulated earnings.

At the time of conversion from a regular plan to a Roth, income taxes must be paid on the full amount converted. With this prepayment of taxes, no taxes then are due when the money is taken out.

The key question

The most critical part of a Roth conversion analysis is the comparison between the taxpayer’s current tax bracket and the tax bracket in which he or she expects to be in retirement. The question is how does one go about making this comparison?

Current tax brackets

Under the current 2012 tax brackets, for the married filing jointly status the Regular Tax 28% bracket is reached at $142,700 of taxable income, the 33% bracket at $217,450, and the 35% bracket at $388,350. Compare this to the AMT bracket of 26% for Alternative Minimum Taxable Income up to $175K, and 28% for everything over that level. 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 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 likely will change. The “Fiscal Cliff” means that, if Congress does not act soon, on January 1 Regular Tax rates will increase, and it will have been even more attractive to do a Roth conversion today rather than waiting until next year. Equally as important is the fact that tax brackets for most folks will be less in retirement than what they are today, simply due to the nature of our graduated tax rate system.

Conclusion

With year-end and the Fiscal Cliff approaching, every individual with a 401(k) or a regular IRA has 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, Legislation/tax law changes | 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 Announces 2012 Inflation Adjustments, Once Again Highlighting the Need for Another Alternative Minimum Tax “Patch”

Friday, October 21st, 2011 | Print This Post | Email This Post

As it does in the fall of every year, the IRS has calculated the effect that inflation has had on the income tax brackets that are used to compute the individual income tax, and it recently has announced what the tax brackets will be for 2012. These adjustments are required under the tax law, but they are limited to the Regular Tax brackets only – no similar adjustments are made for the Alternative Minimum Tax. Unless Congress specifically addresses the issue with another AMT Patch, this mismatch will result in approximately 25 million additional taxpayers becoming subject to the AMT in 2012.

The Patch

The Patch, as it is famously known, is the mechanism used by Congress to offset the failure of the tax law to automatically require an adjustment of the AMT brackets for inflation. This failure, with the resulting need for the annual Patch, has been going on since 2000, over a decade now. The reason for the constant one-year fixes, or “patches,” is simple – it has been estimated that a permanent fix would cost in excess of one trillion dollars. While the one-year fixes in and of themselves are expensive, there is simply no way that Congress could ever find enough money to do a permanent fix in the absence of a complete overhaul of our U.S. tax system.

The AMT exemption

The actual Patch mechanism is the making of an adjustment to the Alternative Minimum Tax exemption amount. For a married couple filing a joint return, for 2011 the exemption amount is $74,450 (other filing statuses have different exemption amounts). What this means is that taxable income for AMT purposes will be $74,450 less than what it otherwise would be, after increasing Regular Tax taxable income for the numerous AMT adjustment items. The purpose of this is to ensure that folks at lower levels of taxable income, and folks who don’t have very many AMT items, are not caught in the AMT net.

What happens if there is no Patch

If Congress does not enact another Patch, the exemption amount will drop significantly, all the way back to what it was in 2000. For a married couple, this would equate to an exemption of only $45,000 – 40 percent less than what it is today. This substantial drop in the exemption would result in the 25 million additional AMT payers mentioned above.

When will Congress act?

Although one can never predict when Congress will get around to doing things, as we have seen time and time again Congress does tend to postpone dealing with difficult issues until the very last moment. Thus, even though these 25 million individuals technically become AMT payers on January 1, 2012, the average time it has taken Congress to enact the Patch is seven months into the tax year. Thus, if they followed this average we won’t know until July, 2012 what the revised exemption amount is. But don’t’ assume July – twice during the past decade it has actually taken Congress until December to enact the Patch.

The “Patch watch”

Congress knows what it needs to do. All that can be done is to wait, and watch and monitor the goings-on in Washington. Future articles will be doing exactly this, and reporting on any developments when they occur.

Posted in AMT Exemption, Calculation of the AMT, Legislation/tax law changes, The "patch" | 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 »

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 »