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Year-End Planner: Don't Forget the AMT

The holiday season is in full swing, but there's one chore you still need to think about: figuring out if you'll be hit with the alternative minimum tax.

The much-bemoaned AMT is casting a wider net each year, which makes advanced planning even more important. And for individuals who might be ensnared, take heed: strategies to avoid the AMT are often the opposite of what you might normally do to pay the minimal amount of taxes.

To determine if you're liable for the AMT, two calculations are necessary. First, you need to figure out your taxes as you normally would. Then you have to figure out how much you would owe under the AMT system, where various deductions-- such as property taxes, state and local income taxes and mortgage interest--aren't allowed. Whichever result is bigger, that's what you pay.

The AMT was established in 1969 to ensure the very wealthiest Americans were paying their fair share of taxes. However, it was never indexed for inflation and has increasingly trapped more upper middle-class and middle-class taxpayers.

High-Tax States

Those most likely to be hit are taxpayers that live in high tax states like New York and California who take many deductions. Households with incomes between $150,000 to $400,000 are at risk, while those that earn between $400,000 and $500,000 are at even greater risk.

The AMT is always painful for taxpayers. Even though its rate is either 26% or 28%, which is lower than the highest marginal tax bracket of 35%--it's applied to a wider base of income. And, unlike the traditional tax code, the AMT isn't a progressive tax, but rather a flat tax. Income up to $175,000 is taxed at 26% and 28% thereafter.

What’s a taxpayer to do? First, try and project your taxable income for both the current and next year. If you expect to be hit by the AMT this year but not next, you may consider some unconventional planning.

“Year-end AMT tax planning is counterintuitive,” says John Nersesian, wealth management strategist for Nuveen Investments in Chicago. “Traditional year-end advice is to accelerate deductions and defer income. Under AMT, it’s the exact opposite.”

So, for instance, there’s no reason to pre-pay something like property taxes normally due in January in order to get the deduction. In fact, if you expect to be subject to AMT this year but not next, you might as well save the deduction for 2007.

Balancing Act

Keep in mind, however, that it’s a delicate balancing act. “The theory is that deductions won’t do you any good, but if you start accelerating income, while that may allow you to avoid AMT, it could be at the cost of raising your regular income tax above what your AMT would have been,” said Bob D. Scharin, senior tax analyst from Thomson Tax & Accounting in New York. “That’s what people have to watch out for.”

“If you are in AMT and expect to stay in AMT, little can be done,” adds Clint Stretch, director of tax policy for Deloitte Tax LLP in Washington.

The number of taxpayers subject to AMT more than tripled between 2001 and 2005 from 1.4 million to 3.6 million, according to the Tax Policy Institute. The number would have swelled to 22 million in 2006 if the exemption wasn’t increased. However, the Tax Increase Prevention and Reconciliation Act of 2005 increased the AMT exemption for married couples to $62,550 ($42,500 for singles) from $58,000 in 2005 (or $40,250 for singles).

Without further Congressional intervention, the AMT exemption will revert back to 2000 levels next year and capture an estimated 23 million in 2007, the institute says. That compares with only 20,000 taxpayers affected in 1970.

While the incoming Democratic Congressional leadership has said it wants to make reforming the AMT a priority, the costs to the federal government to repeal it make that a difficult proposition: it would cost $1.3 trillion over the next ten years. Consequently, Congress has relied on short-term fixes.

Concludes Deloitte’s Stretch: Congress “may take care of it with two more years of Band-Aids, but at some point they’ll have to do a more serious (fix).”