Tax Bill Curtails AMT Burden
The only thing less popular than paying taxes is to have your time wasted doing it. For those under its umbrella, the additional complications of the Alternative Minimum Tax (AMT) can be especially unpleasant. Essentially, you have to do your taxes twice. The Tax Policy Center put it best, calling the AMT “the epitome of pointless complexity.” However, relief may be on the way.
When you fall in to a certain income range, you need to determine your normal income taxes and the AMT, then pay any additional balance on top of your regular income tax if the AMT is higher. In recent decades, many people have been subject to the AMT; many more have been required to spend hours filling out worksheets and forms to figure out whether they owe it or just the regular income tax.
Possibly the most frustrating aspect is that many people who go to the trouble of filling out the AMT form will find that, in the end, they don’t owe the tax. The IRS has been keeping a sharper eye out for AMT-related mistakes, so it’s in your best interests to fill out the AMT worksheet (find a link at the end of this article), or to hire a professional to help you out if you’re unsure about your return (any good do-it-yourself tax software should include an AMT questionnaire and calculate it for you as you fill out your return as well, although your mileage may vary with such programs).
But there’s good news. While tax professionals are still wrapping their heads around every facet of the Tax Cuts and Jobs Act of 2017 (TCJA) signed into law in December, it’s possible that fewer people will be subject to the AMT in the years ahead as a result of the new legislation.
As a refresher, the AMT functions alongside the normal tax code as an additional levy on people the IRS deems to not be paying enough in regular taxes, with different rates and methods of calculating income and deductions. Congress created it in 1969 after finding 155 taxpayers with incomes above $200,000 had avoided paying federal income tax. Legislators subsequently created a parallel tax system to prevent high-income taxpayers from claiming deductions that allowed them to pay little to no tax. The AMT expanded the income that is taxed by including items that are tax-free and prohibiting many deductions allowed under the regular tax system.
The most common factors that subject taxpayers to the AMT: State and local taxes (including property taxes); personal exemptions and the standard deduction; miscellaneous itemized deductions; tax-exempt interest income from specific private-activity bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates.; income gained by exercising incentive stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. options; and differences in tax basis of fixed business assets in connection with depreciation or sale of an asset.
The problem with the AMT emerged because it wasn’t linked to inflation, ensnaring more and more middle-income taxpayers as time went on. Since the passage of the American Taxpayer Relief Act of 2012, it’s now linked to inflation, like Social Security. This meant that if you didn’t have to pay it last year, you wouldn’t have to pay it in the following year unless your income or tax liabilitiesLiabilities are calculated by adding up your existing debts (mortgage, car loans, student loans, credit cards, etc.). went up faster than inflation.
The new tax bill raised the income limits on the AMT for individuals by a significant amount, easing the burden on upper-middle-class households. The AMT exemption for single filers in 2017 was $54,300, and it began to phase out once income levels hit $120,700.
Source: Tax Policy Center.
The new tax law temporarily ups the single-filer exemption to $70,300 and begins the exemption phase-out at $500,000. For married couples filing together, the exemption level climbed to $109,400, with the phase-out coming at $1 million. These increased exemptions aim to subject many fewer taxpayers to the AMT in the years 2018 to 2025, after which they are currently scheduled to expire. The Joint Committee on Taxation expects the smaller pool of AMT taxpayers to reduce federal revenue by more than $637 billion over the next decade.
Source: Tax Policy Center.
The increased exemption and phase-out thresholds under the TCJA do not apply to trusts and estates, which will continue to be indexed to inflation on an annual basis.
A key component to figuring out whether you still need to pay the AMT is how it will interact with other changes to the tax code, namely the standard interest deduction and limitations on itemized deductions (including mortgage interest and state and local property or income and sales tax).
The TCJA’s larger standard deduction (doubled from 2017 levels to $24,000 for joint filers for tax-year 2018) combined with limitations on itemized deductions means more households will likely benefit from the simpler choice of taking the higher standard deduction, which in turn leaves them less likely to be liable for AMT dues.
For those taxpayers not subject to the AMT, individuals will only be able to claim an itemized deduction of up to $10,000 (or $5,000 if married and filing a separate return) for the combined total of state and local property taxes and state and local income taxes.
Charitable donations can still be itemized and deducted under the new law. But in eliminating most other itemized deductions, the tax bill doubles the standard deduction. As a result, many people who formerly itemized deductions may opt to file for the standard deduction instead.
The taxpayers who will remain subject to the AMT are more likely to be high-income households in states and towns with relatively higher taxes. Since the value of state and local tax deductions and the mortgage interest deduction are limited, fewer households in the $200,000–$500,000 income range will be affected. With exemptions not phasing out until the $1 million threshold is reached, households that exceed a seven-figure income will pay a larger share of the AMT.
We urge you to contact a tax professional if you are unsure of how the rule change will affect you. And for those who still fall under the AMT’s yoke, there are a few options in the fund world that may lessen the burden.
Funds to Fight the AMT
Fidelity, along with several other mutual fund companies, has taken some steps towards helping investors stave off paying the AMT, though we’ll be watching to see how the new tax code affects the popularity of these options.
The firm currently offers six AMT-sensitive municipal money market funds (AMT Tax-Free Money Market, California AMT Tax-Free Money Market, Massachusetts AMT Tax-Free Money Market, New Jersey AMT Tax-Free Money Market, New York AMT Tax-Free Money Market and Tax-Free Money Market), and two AMT-sensitive bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. funds (California Short-Intermediate Tax-Free BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. and Tax-Free Bond), which seek to invest only in securities whose interest is exempt from the AMT (and normal income taxes as well). While these funds can provide AMT protection when used in a wide-reaching tax strategy, don’t expect them to prevent you from having to calculate the AMT just because you hold them. And it probably goes without saying that money market funds are far better as cash management tools than long-term investments due to their stable share prices and low yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price..
Vanguard does not provide any AMT-free funds as of yet, instead limiting a number of its tax-exempt, fixed-income funds’ holdings to a max of 20% of assets in bonds with interest subject to the AMT. The reason, according to Vanguard’s Fixed Income Group, is that eliminating AMT-taxable bonds would reduce diversificationA strategy for managing investment risk by investing in a mixture of different investments. Since different asset classes face different risks, even if one type of asset declines in value, others may not. and lower the yields of certain funds.
Dealing with the AMT
There’s no getting around it: The AMT remains a confusing topic that taxpayers may be tempted to avoid, and it’s a step in the right direction to have fewer people impacted by it. But be warned: Every taxpayer is required to figure out whether they owe money due to the AMT, and the failure to fill out the IRS’ AMT Worksheet to determine liabilityLiabilities are calculated by adding up your existing debts (mortgage, car loans, student loans, credit cards, etc.). and, if required, to file Form 6251, can be a red flag for IRS auditors. It’s a time commitment, but it is fortunately one that can be simplified by many of the tax preparation software options and websites available (or by having a tax professional prepare your return for you).
Mutual fund families may be able to help out to a small extent by offering more AMT-free funds, but these are not the kinds of funds most investors will flock to, at least for a majority of their assets. Our best suggestion is to consult with a tax specialist or certified public accountant if it seems as though you’ll have to pay the AMT or if you’ve paid it in the past. While the AMT is an additional burden, at least you’ll have the peace of mind knowing that your returns were correctly calculated and that the IRS won’t be coming after you for interest and penalties on unpaid taxes.
This material is distributed for informational purposes only. The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.
Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.
Past performance is not an indication of future returns. The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. We do not provide legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
The Barron’s rankings consider factors such as assets under management, revenue produced for the firm, regulatory record, quality of practice and philanthropic work. This award does not consider client experience and is not indicative of future performance.
Editors at the Financial Times bestowed “elite” status on 300 firms in the U.S., as determined by assets under management, asset growth, longevity, compliance record, industry certifications and online accessibility.
© 2018 Adviser Investments, LLC. All Rights Reserved.