Alternative Minimum Tax

The alternative minimum tax (AMT) was originally established in 1969 to target 155 high-income taxpayers who had used deductions to completely avoid paying federal income taxes. Since then, the AMT’s reach has spread significantly, affecting many taxpayers for whom it was never intended.

Why the AMT usually means paying more taxes

Any tax called "minimum" may at first seem like a blessing, but more often than not, being subject to the AMT means paying a higher tax bill. The AMT typically targets taxpayers with sizable long-term capital gains and deductions relative to their ordinary income. It prohibits any deductions outside of charitable contributions and mortgage interest, including miscellaneous itemized deductions, property taxes, and state taxes. Those who may fall under the AMT must calculate their taxes twice, once under the regular tax system and once under AMT rules. They must pay whichever bill is higher.

Who is at risk for the Alternative Minimum Tax?: Retirees Behind the Eight Ball

For taxpayers who have considerable deductions compared to their ordinary income, the AMT poses a significant threat. If you run a home-based business or live in a high-tax state such as California or New York, sizable deductions could put you in AMT range.

If the bulk of your income comes from long-term gains, this may also trigger the AMT. Although the same long-term capital gains rate of 20 percent applies under the AMT, substantial deductions could push your regular tax calculation below the AMT floor. Income from a pension, dividends, or an IRA can help you avoid reaching AMT territory.

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Recent tax breaks and the fact that the AMT is not indexed for inflation will further stretch its reach in the coming years. Between now and 2010, the number of households affected by the tax is expected to rise from 2.7 million to more than 35 million.

Though opposition to the tax is gaining steam, most experts agree that a repeal is unlikely because of the amount of revenue generated by the AMT — between $12 billion and $54 billion a year for the next eight years.

The AMT is one of the most complex and grueling items in the tax code. But with long-term planning and a proper tax strategy, you may be able to develop the right approach for addressing its impact.

Note: Before you take any specific action, be sure to consult with your tax professional.