Plotting a Practical Investment Strategy

The alternative minimum tax (AMT) was once an obscure provision in the tax law meant to ensure that Americans with high incomes could not take advantage of certain preference items to avoid their fair share of taxes. In recent years, however, more and more taxpayers have been subject to the AMT. The AMT may result in additional tax you would have to pay with your regular income tax if your tentative minimum tax on your alternative minimum taxable income (which includes certain tax-free income), after an exemption amount, exceeds your regular tax.

Concerned about the AMT?
Consider the Tax-Exempt Money Fund1 or Tax-Free Income Fund

As the reach of the AMT has broadened, it has become increasingly controversial and is causing considerable concern among investors. T. Rowe Price believes that its clients should be aware of the potential impact of the AMT without letting it dictate their investment decisions. This information will help to explain:

There's no hard and fast test to determine if you will have to pay the AMT. You must first calculate your taxes using the standard IRS rules, and then do a second calculation using the AMT rules. If your AMT total is higher, you must pay that amount.

In general, you may be affected by the AMT if you:

  • Are in a relatively high income tax bracket.
  • Live in a high-tax state.
  • Take a large number of exemptions for dependents.
  • Have substantial miscellaneous and medical expense deductions.
  • Exercised incentive stock options and did not sell the stock in the same year.
  • Deducted interest paid on a second mortgage not used for residential purposes.

If you're unsure whether you must pay the AMT, speak with your tax advisor. You also can determine your status by completing the AMT calculation provided by the IRS on Form 6251 or by using appropriate tax software.

Avoiding the AMT should not be your primary investment goal. However, if you are concerned about the effects of the tax, here are a few simple steps you can take to minimize your exposure:

Choose AMT-free municipal bond funds and money market funds. Not all municipal bonds offer AMT-free interest. For example, municipal bond funds investing in private activity bonds may result in interest income not exempt from the AMT. Check your fund's prospectus to see if a portion of its income comes from these bonds.

Spread out your gains. If possible, spread out your capital gains from the sale of securities or the exercise of incentive stock options over several years.

Plan your income and deductions. Develop a multi-year tax plan that carefully times your income and use of deductions. For example, you can take steps to accelerate your investment income to concentrate your AMT liability into one year, while deferring deductions. This lets you apply your deductions in a year when you can take full advantage of them.

Note: T. Rowe Price offers two funds whose income is entirely AMT tax-free—the T. Rowe Price Tax-Exempt Money Fund1 and the T. Rowe Price Tax-Free Income Fund.

Use a donor-advised fund to coordinate your charitable contributions with the rest of your investment plan. You may make your tax-deductible donations in the years when the deductions will provide maximum benefits and then request distributions to your favorite charities in future years without worrying about the AMT.

If you want a simple, effective way to organize charitable donations, consider opening a donor-advised fund with The T. Rowe Price Program for Charitable GivingSM.2

While you should consider the impact of the AMT, it should not be the primary factor in your investment decisions.

When you plan your portfolio, your top priority should be sticking to fundamental investment principles such as proper asset allocation and diversification. Look closely at your individual goals and time horizon to create a portfolio that contains a mix of stocks, bonds, and money market securities that's right for you. Only after those steps should you consider ways to fine-tune this strategy in order to address the AMT.

While you may think that avoiding the AMT always will be beneficial, it actually could cost you money. By investing solely to limit your AMT liability, you may lose out on higher potential income or growth opportunities.

Don't let the AMT take control of your investment decisions. If you have any questions about the AMT's impact on your investment decisions, call us at 1-800-638-5660 for guidance from our investment representatives. You should note, however, that we do not provide tax advice. Therefore, you also may wish to consult your investment or tax adviser.

Although the costs and complexities of the AMT have caused growing concern among taxpayers and legislators, it appears that it may stay on the books for a while longer. Any revenue lost from eliminating the AMT would likely have to be replaced. Current estimates place the cost of repeal at between $800 billion and $1.5 trillion over a 10-year span.

Fortunately, the American Taxpayer Relief Act of 2012 made permanent AMT "patches" that temporarily increased the AMT exemption amount to protect millions of middle-income taxpayers. According to the Tax Policy Center, the law also indexes the exemption for inflation, which should hold the number of taxpayers subject to the AMT steady at about four million per year.

1An investment in the T. Rowe Price Tax-Exempt Money Fund is not insured or guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

2The T. Rowe Price Program for Charitable Giving is an independent, nonprofit corporation and donor-advised fund founded by T. Rowe Price to assist individuals with planning and managing their charitable giving.