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What you need to know about the dreaded Alternative Minimum Tax

The Alternative Minimum Tax (AMT) was introduced in 1969 as a way to ensure that extremely high-income taxpayers paid their fair share. For the 1967 tax year, just before the tax was first enacted, 155 taxpayers with incomes of more than $200,000 (indexed for inflation, that's roughly $1.3 million today) didn't pay a dime in federal income tax. Of those 155 taxpayers, 20 were considered millionaires, with incomes that would be valued at more than $5.9 million in today's dollars.

But something strange happened with the AMT. The government never indexed the tax for inflation, meaning it started affecting a growing number of people as wages and other earnings kept pace with inflation. Additionally, a number of traditionally "high wage earner" tax preference items, like stock options, became more popular with middle class taxpayers. By 1970, more than 19,000 taxpayers were affected by the tax.
More than four decades after the tax was first created, Congress still hasn't implemented a fix. For 2010, the AMT is expected to affect one in five taxpayers. In most years, however, Congress has tackled the gaping hole in the AMT by applying a "band aid" to the exemption amount in the form of a small increase.

Will you be hit by the AMT?

Generally speaking, you may be subject to the AMT if your taxable income for "regular" tax purposes, plus any adjustments and tax preference items, results in an amount higher than the AMT exemption amount. For 2009, the AMT exemption amount has increased to $46,700 for individual taxpayers. The AMT exemption is $70,950 for married taxpayers filing jointly or for qualifying widow(er)s, and $35,475 if married filing separately for 2009. These exemption amounts will drop to $33,750 for single taxpayers, $45,000 for married taxpayers filing jointly or for qualifying widower(s), and $22,500 if married filing separately in 2010.

If the AMT applies to you, then you must separately calculate a second tax by eliminating many deductions and credits. Whichever amount is higher is the amount you pay.

What you need to know if you're impacted by the AMT

If your income is high enough, there's virtually no way to completely eliminate the AMT, though there are some planning techniques to mitigate the often unwelcome effects. It pays to be aware of how your tax return is affected by the tax. Here are some transactions that can trigger or be affected by the AMT:

State and Local Taxes. If you live in a high tax state (like New York or Hawaii) or a municipality with high taxes, the good news is that you can deduct those taxes on your Schedule A if you itemize. The bad news is that it's a tax preference item which could subject you to the AMT -- and you could lose the deduction.

Medical Expenses. You can itemize these expenses on your Schedule A. AMT, however, limits this deduction. If you have high medical expense deductions and are affected by the AMT, expect to lose out.

Mortgage Interest Deductions. A second mortgage may be affected by the AMT. If you take out an extra home loan for purposes other than to buy or improve your home, the interest deduction isn't allowed under the AMT.

Miscellaneous Itemized Deductions. If you claim a large number of miscellaneous itemized deductions (like unreimbursed job-related expenses or tax preparation fees), those expenses may be eliminated by the AMT.

Incentive Stock Options (ISOs). ISOs are one of the most common triggers of the AMT. It used to be largely the wealthy CEOs and closely-held business owners who exercised stock options. But in the 1990s, many companies (tech companies, in particular) began to use stock options as a method of compensation. It was great for the companies, because they were not out of pocket any cash. But it wasn't so great for many taxpayers; the exercise of a large stock option package subjected the gain to the AMT, even in instances when the stock is not sold (and income would otherwise not be realized).

Foreign Tax Credit. If you're subject to the AMT, a portion of the foreign tax credit will be disallowed. The foreign tax credit allows an offset for taxes paid to other governments for American citizens living abroad. Disallowing the offset means that taxpayers could be subject to the dreaded "double tax" on the same income.

Exemptions. The more exemptions you claim, the more likely it is you'll have a resulting AMT liability. That doesn't mean the exemptions will necessarily trigger the AMT, but personal exemptions do contribute to AMT since they're considered a tax preference item. The AMT disallows personal exemptions as if they simply don't exist.

If your income is above the exemption amount and think you might be subject to the AMT, you'll need to complete form 6251, Alternative Minimum Tax - Individuals. You can also try an electronic version of the form on the IRS Web site.

Interestingly, the AMT is considered one of the most complex pieces of the Tax Code, even though it's basically a flat tax of about 28% after adding back in most deductions. While many taxpayers purport to clamor for a simpler system, reducing deductions and credits actually results in paying more tax. Taxpayers love their deductions and exemptions, which the AMT largely eliminates.

What makes the AMT so complicated -- and, to some, unfair -- is that it's an additional layer of tax. If you're not paying an amount of "regular" income tax in keeping with your level of income, you have to make up the difference by paying the AMT. This is one situation where it pays to be normal.

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