TAKE NOTE feature

The Alternative Minimum Tax

The new tax laws exempt millions of middle-class taxpayers from the AMT. What steps can help you manage and minimize your exposure to the tax?

he American Taxpayer Relief Act of 2012 finally provides certainty on the alternative minimum tax (AMT) exemption amounts, which will be indexed for inflation beginning in 2013. In the past, the exemption amounts were not indexed for inflation, and Congress passed temporary fixes year after year to avoid broadening the tax' reach. The new rules remove uncertainty in your AMT exemption amount, enabling you to assess your AMT situation by reviewing other relevant factors, including your annual income, the size of your family, the nature of your investment gains, and even your home state. Knowing if you are likely to owe the AMT gives you the opportunity to take steps within your broader financial planning strategy to minimize your exposure.

THE AMT: THEN AND NOW
Congress created the AMT in 1969 to impose a minimum tax on wealthy taxpayers who managed to pay little or no income tax each year by claiming multiple tax credits and deductions. The AMT formula replaces itemized deductions with tiers of standardized tax rates for different income levels and sets a specific exemption that can be subtracted from your alternative minimum taxable income. Taxpayers must calculate their taxes using both the standard rules and the alternative minimum formula, and then pay whichever tax amount is higher.

• $51,900 for single filers
• $80,800 for married couples filing jointly

The amounts will be indexed for inflation. The new formula should hold the number of taxpayers who owe the AMT steady at about 4 million per year, according to the Tax Policy Center.

The 1969 law failed, however, to automatically adjust the AMT exemption amount for inflation. That oversight meant that as the decades went on, millions of middle-income taxpayers found themselves owing the AMT. As a result, Congress passed several one- or two-year “patches” that temporarily increased the AMT exemption amount. The new law replaced this ad hoc approach with a permanent fix.

DO I HAVE TO PAY THE AMT?
Even with an indexed exemption amount, it can be difficult to know if you will owe the AMT because of the way the tax is calculated. Based on the tax' income threshold, filers who are more likely to pay the AMT include those with annual incomes between $200,000 and $1 million. (Taxpayers earning more than $1 million in annual income are less likely to pay the AMT because they already pay a higher regular tax rate than the top AMT rate.) The AMT also doesn't allow many important exemptions and deductions, such as mortgage interest, property taxes, dependent credits, and state income tax. As a result, married couples; families with two or more children; and residents of high income tax states, such as California and New York, also are likely to owe the AMT.

MANAGING YOUR AMT LIABILITY
If you paid the AMT last year, you should be prepared to pay it again this year. And if you believe that changes to your income or life circumstances may push you above the AMT exemption in the future, consider the potential impact of that tax in advance. Although taxes should never be the primary consideration when making investment decisions, you can make use of tax planning techniques that can reduce the AMT' impact on your finances.

For example, you can diversify your taxable investment portfolio with funds that offer AMT-free interest, such as certain municipal bond funds and tax-exempt money market funds. However, not all municipal bond interest is AMT-free, so check a fund' prospectus to see if any of its returns are from certain private-activity municipal bonds whose income is subject to the tax.

You also can manage annual capital gains to reduce your AMT liability—an example would be spreading the capital gains from the sale of securities over a number of years, which can enable you to avoid having a large one-time gain that pushes your income above the AMT exemption threshold in a single year. Speak with your financial advisor or tax planner to see whether these or other techniques can help increase your tax efficiency and reduce the potential impact of the AMT.

WATCH FOR CHANGES IN TAX LAW
Remember that the permanent AMT exemption fix doesn't mean your family is permanently protected from this tax. A raise, a new job with a higher salary, or additional income that would result if your spouse returned to work could push your household income above the AMT threshold. Claiming more high-value deductions each year also could trigger your family' AMT liability. Consider contacting your advisor or tax planner after any of these events to determine whether they call for changes to the tax planning component of your financial strategy. While the new AMT rules don't exempt everyone from the tax, they do make it possible to develop effective long-term plans to reduce or avoid the AMT when circumstances allow.

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