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Watch Out for the AMT: Triggers and Strategies to Limit Your Exposure

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If you live in California and especially in the Bay Area, you likely have encountered the alternative minimum tax (AMT).

What is it? It’s a method of calculating your income tax in parallel with the standard method. The AMT was introduced in 1969 to prevent high-income earners from avoiding income tax by loading up on deductions. The AMT taxes certain types of income that are tax-free under the standard method, and disallows some tax deductions that are allowed in the regular system. You will owe the higher of the two tax liabilities calculated by each method.

While the AMT was initially intended to make sure high-income earners pay some taxes, today it is affecting more middle- and upper-middle-income families, making it more important than ever for taxpayers to understand the triggers and the strategies to limit their exposure.

AMT Triggers

While a number of items can contribute to taxpayers paying the alternative minimum tax, these are the main culprits:

  • High state and local taxes: This affects individuals who live in areas with high state and local income taxes and real estate taxes such as California. Deductions for state and local income taxes including property taxes are disallowed under the AMT rules.
  • Large personal exemptions: Personal exemptions are not deductible in the AMT method.
  • Incentive stock options (ISOs): Exercising options does not have an impact on income when calculating the standard tax liability, but the “bargain element,” which is the difference between the stock price and the grant price when ISOs are exercised, is considered taxable under the AMT.
  • Significant home equity mortgage interest: Under the AMT rules, you cannot deduct interest on these loans if the loans are used for any purpose other than financing a home or making home improvements.
  • Miscellaneous itemized deductions: Deductions such as tax preparation fees, investment expenses and unreimbursed employee expenses are not allowed under the AMT.
  • Private activity bonds: Interest income from these municipal bonds is taxable under the AMT method.

Manage Your AMT Exposure

  • Maximize your retirement contributions: Participating and maxing out any employer tax-deferred retirement plans at work such as a 401(k) or 403(b) will lower your taxable income. If you qualify, make deductible IRA contributions as well. For the self-employed, max out contributions to your SEP IRA, SIMPLE IRA or solo 401(k).
  • Use health savings accounts (HSAs) and flexible spending accounts (FSAs): If your employer offers a qualified high-deductible health plan, you can contribute to an HSA account. You can build your HSA with pretax contributions for future health costs, and the account is portable. Similarly, you can contribute pretax money into an FSA for both medical expenses and dependent care—i.e., child care costs.
  • Manage your ISOs carefully: Because exercising ISOs creates an AMT income event, you should work with a tax professional ahead of time to formulate a timely strategy for when to exercise the option and when to sell the stock.
  • Invest in municipal bonds wisely: Invest in tax-exempt bonds that are not private activity bonds since the interest on private activity bonds is taxable under AMT rules.
  • Lower your taxable investment income: Since capital gains are included in AMT income, offset realized capital gains with losses, or defer large gains to another year where you may not be exposed to AMT.
  • Delay paying your property taxes and taking other deductions: Defer paying part of your property taxes to a year where you may not fall into the AMT. The value of property tax deductions and others may be lost under the AMT.
  • Review your AMT exposure in previous years: Look at Form 6251 in your previous tax returns to see which items pushed you into the AMT, and determine whether those items will affect you in the upcoming years.

Learn to Deal with the AMT

While we may not be able to eliminate the alternative minimum tax, there are ways to mitigate its effect on what we owe come tax time. The key is understanding what deductions are eliminated under the AMT method, and what items increase your AMT income. Planning ahead and working with a tax professional to manage the relationship between your taxable income and deductions can help you avoid a big tax surprise.

Disclaimer: Consult your tax advisor before taking any action on topics discussed in the blog.

 

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This blog is provided by NewFocus Financial Group, LLC (“NewFocus” or the “Firm”) for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. No portion of this blog is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this presentation is derived from sources that NewFocus believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.

NewFocus is an SEC registered investment adviser owned by Chad Burton and Robert Black which maintains a principal place of business in the State of Washington. The Firm may only transact business in those states in which it is notice filed or qualifies for a corresponding exemption from such requirements. For information about NewFocus' registration status and business operations, please consult the Firm's Form ADV disclosure documents, the most recent versions of which are available on the SEC's Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov.

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