Understanding the alternative minimum tax

Many taxpayers aren’t aware they’re subject to a little-known tax, called the alternative minimum tax or AMT, until they’ve slogged their way through lots of paperwork, or received an unexpected surprise during an IRS audit. AMT can get complex and tedious quickly, so here’s what you need to know about the tax and your exposure to it. Please note that E*TRADE from Morgan Stanley is not a tax advisor, nor do we provide tax advice. You should always contact your tax advisor for information specific to your situation.

Originally signed in 1969 to prevent wealthy taxpayers from using loopholes to pay little to no taxes, today the AMT affects millions of middle-class families it was never intended to target. Congress passed a measure to tie exemptions to inflation beginning in 2013. The Tax Cuts and Jobs Act of 2017 (TCJA) made additional modifications to the individual AMT that are intended to help lower income households avoid the tax.

The easiest way to understand AMT is to view it as a separate, parallel tax system, reducing some of the tax benefits higher income families use to lower their tax bills. AMT also has its own set of deductions and different tax rates that overall are more onerous on the taxpayer.

Any taxpayer could potentially be subject to AMT. As a general rule, anyone with gross annual income above the applicable exemption amount who claims deductions for expenses that are added back in the AMT calculation process should consider how this tax may potentially affect them.

The best way to determine if you owe the AMT is to fill out the regular tax form, as well as Form 6251[ES1], which essentially adds back certain deductions to calculate the alternative minimum taxable income. You pay whichever bill is higher. (The IRS offers an AMT Assistant online that tells taxpayers whether or not they need to pay the tax, but not the amount they owe.) 

If you are subject to the AMT, you’ll see a big difference in what you can deduct. Many items that are deductible on a regular tax return are either not deductible through AMT or are treated differently, including:

• state, local, and property taxes
• foreign tax credit
• investment expenses
• some medical and dental expenses
• interest from some private-activity bonds

AMT also requires taxpayers to pay taxes on the spread between the market price and the exercise price of incentive stock options granted by their employer.

It's difficult to avoid the tax altogether, but there are ways to potentially lower the burden. 

For instance, though state, local, and foreign taxes are not deductible under AMT rules, you can deduct the refunds, which are considered income under regular tax rules. 

Also, if you are part of an equity compensation plan, you may be taxed on the spread on your incentive stock options, the tax basis for the shares you bought is higher under the AMT. That means your tax bill may be lower when you sell the shares.

While the AMT takes away exemptions and many deductions, it does provide AMT-specific exemptions. The amount varies by filing status and starts to phase out once your income reaches a certain threshold. This means the higher your income, the higher your AMT tax rate. In 2022, the AMT exemption is $118,100 for joint filers and begins to phase out at $1,079,800. For unmarried persons, the exemption is $75,900 and begins to phase out at $539,900. The amount of income after the exemption is subject to AMT rates of 26% on the first $206,100 and 28% on anything above that. Since Congress changed AMT to adjust for inflation, the AMT exemption amount adjusts every year. 

Finally, you may be able to claim your current year AMT payment on your tax return in future years. To find out if you qualify, complete Form 8801.

Visit the E*TRADE Tax Center (logon required).