The AMT is not the same thing as an ATM, but read it quickly, and you're likely to mistake it for the machine that spits out cash.
The alternative minimum tax, however, tends to take money away from you.
If you've ever been hit by the AMT, you're likely craving a more serious explanation, so here's a short history of what this tax is, who it affects and what you can do to potentially sidestep it.
How the AMT Came to Be
The AMT is an “alternative” tax that is calculated at the same time as regular income taxes, and you, as a taxpayer, are typically asked to pay whichever is greater. If the AMT applies to you, you may lose many credits or deductions you would normally receive if you didn’t have to pay the AMT.
The concept of an alternative minimum tax didn't always exist: According to the I.R.S., It was created in 1969 to keep the wealthiest taxpayers (and corporations) from using loopholes or big deductions to avoid paying a minimum amount of taxes. However, the tax has never been indexed to inflation, so as wages increased, it has started to affect more middle class Americans than ever before.
In 1970, less than 20,000 people paid the AMT; In 2012, a huge number of Americans—about 4 million—were projected to be hit by it. The majority of those paying the tax, originally intended to target the "one percent," make between $150,000 and $200,000. In fact, in 2011, just over 53% of households with annual earnings of $200,000 to $500,000 paid the AMT, while only 33.5% of those making an annual income of $1,000,000 did, according to the Tax Policy Center.
In 2013, Congress passed a permanent patch to index future exemption levels to keep pace with inflation, which will, hopefully, mean that fewer people will be exposed to this tax in the future.
How is the AMT administered—and who is likely to pay it?
"It’s very difficult to tell if you’ll have to pay AMT by income alone because there are so many factors that go into determining this calculation," says Shana Bickel, a certified public accountant based in Sarasota, Fla. There are a few things to watch out for that can trigger AMT—some you can control and some you can’t, she says. The best way to see if you are close to paying the AMT is to look at Form 6251 from last year's tax form.
The people who are most likely to pay the AMT have incomes over $100,000 and very large deductions. Below you will find a list of situations that could leave you vulnerable to owing the AMT. If you fall into one of these categories, and your income is above $100,000, you may want to talk to your CPA or tax accountant to see if there is any tax planning you can do to potentially avoid it.
High City, State, and Property Taxes
You are more likely to pay the AMT if you live in a state with high local, state, or property taxes such as: New York, New Jersey, California, and Connecticut.
High Medical Expenses
If you’ve had major medical bills this year and are able to deduct the majority of them, this could actually expose you to the AMT since your itemized deductions are higher.
You Have a Big Family
If you have lots of children, you may also qualify for other credits like the dependent care tax credit and the American Opportunity Credit for college-age children. Tax credits are normally a good thing because they lower your traditional tax bill, but the downside is that you could find yourself having to pay the AMT. The more tax credits you have, the more likely you are to pay the AMT.
RELATED: 6 Ways to Save on Childcare Costs
Interest Deductions from Second Mortgages and HELOCs
If you used a second mortgage or HELOC to consolidate your debt or pay for your child’s college, you likely won’t be able to deduct that under the AMT rules. (Typically, there are limits to the amount of debt for which you are eligible to deduct the interest.)
Long Term Capital Gains
We tend to think of long term capital gains as a good thing because they generally are taxed at a lower rate than earned income. However, large long term capital gains can reduce the AMT exemption amount, which can result in having to pay more tax.
Incentive Stock Options (ISOs)
If you work for an employer that offers ISOs and you decide to exercise them, the difference between the purchase price and the grant price is subject to the AMT (but it is not subject to regular taxes). You may want to consult with your CPA or tax accountant if you are considering exercising ISOs.
There are many different tax strategies than can be used to hedge against this. If you have non-qualified stock options (NSOs) in addition to ISOs, there are some tax strategies you may be able to use to minimize your chance of owing the AMT. In this case you might want to consult a financial planner, as well as your CPA, so you can know how this will affect not only your tax situation, but also the allocation of your entire portfolio.
What to Watch Out for If You Have to Pay the AMT
"Many people have incomes over $100,000 and do not have to pay the AMT, so don’t worry too much if your income is high, just make sure you check out Form 6251 and see how close you are to paying the AMT," says Bickel.
If you’re already paying the AMT, then you may want to consult a CPA or tax professional to help you with tax planning for the year. Also, a financial planner may be helpful in collaborating with your CPA to help implement different tax strategies to reduce your overall tax liability.
Steps You Can Take to Not Pay It
In addition to increasing your contributions to your retirement plans, like 401(k)s and 403(b)s, you should also take advantage of other employer benefits like dependent care reimbursement through a Flexible Spending Account, rather than claiming this deduction on your tax return. Taking these steps may help to lower your taxable income and may keep you from paying the AMT.
If you are paying AMT, you are most likely (but not always) a higher income earner and may benefit from working with a tax professional and financial planner to make sure you’re implementing the right strategies for your situation.
LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc. that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment advice. Please consult a financial advisor for advice specific to your financial situation.