Each presidential election cycle, conversations inevitably start about our country's tax code and each candidate's plan to change it. And before we go any further, don't worry, we won't be discussing politics in this article. But when these conversations begin, the focus is often centered on decreasing taxes for the middle and lower class and increasing taxes for the wealthy. This election cycle, there have been recommendations made as to how to change a type of tax that is not very well-known or understood: The Alternative Minimum Tax.
The Alternative Minimum Tax is a form of taxation designed to ensure that wealthy individuals pay what's considered a fair share of taxes on their income. Because of the increased number of tax deductions available to wealthy persons for things such as investment income, business losses and real estate holdings, prior to the Alternative Minimum Tax these individuals could use the rules of the tax code to make sure they paid literally no taxes at all. They would simply use these myriad deductions available to reduce their income to the point where there were no taxes due. To understand how it's possible to pay no taxes, let's do a quick recap of how the IRS determines the amount of income on which you will pay taxes (check out a more detailed description of how taxes work here):
How Taxes Work
1. When filing taxes, the first step is to total up all your sources of income (salary, part-time employment, rental income, etc.). The total of these amounts is called your gross income.
2. The next step is to subtract what are called above the line tax deductions. A tax deduction is a tool that is used to reduce the amount of income on which you will pay taxes. An example of an above the line tax deduction is the amount of money you might contribute to a traditional retirement account. As an example, if you make $100,000 gross income and have $5,000 of above the line tax deductions, these deductions reduce the amount of income on which you pay taxes to $95,000. The amount of income left after your above the line tax deductions is called your Adjusted Gross Income (AGI).
3. After you've subtracted your above the line tax deductions to find your Adjusted Gross Income, you then decide whether to use the IRS standard deduction or to "itemize" your own deductions. The standard deduction is a set number for your household that the IRS allows you to use to reduce taxable income even further. In 2020, the standard deduction for a single taxpayer is $12,400, and doubles to $28,800 for married couples filing joint. Let's go back to our example of a person who made $100,000 in gross income and used above the line tax deductions to reduce their taxable income to $95,000. If they are single and use the standard deduction of $12,400, their taxable income would be reduced from $95,000 down to $82,600. This change is if they decide that the standard deduction decreases their taxable income lower than what it would be if they simply added up all their own deductions they accrued throughout the year. These types of tax deductions that you would use instead of the standard deduction are called itemized or below the line deductions. Examples include charitable contributions, medical expenses and even some business expenses. If the person in our example totals up their itemized deductions and finds that they can be used to the decrease their income even lower than what's offered by the standard deduction, they would choose to itemize instead. But for now, let's assume they simply use the standard deduction.
4. After the standard deduction has been applied, the amount of income left is considered taxable income. This is the dollar amount that will be used when calculating your taxes. After it is applied to the different tax brackets, which is a longer conversation for another day, the amount of tax you owe is determined. But that's not the last straw because there's one more tool that can be used to reduce your taxes: tax credits
5. While tax deductions are tools that are used to reduce your taxable income, tax credits are tools that are used to reduce the actual taxes that you pay. As an example, a person earning $100,000 can use a $5000 tax credit to reduce their taxable income to $95,000. But a person who owes $10,000 in taxes can use a $5,000 tax credit to reduce the taxes owed to $5,000. An example of a tax credit is the Child and Dependent Care Credit
In the 1960s, the government found that people were using these deductions and credits to show no income at all, thus avoiding taxes. And to remedy this situation, the Alternative Minimum Tax was born.
What is the Alternative Minimum Tax?
The Alternative Minimum Tax (AMT) is essentially a second way of calculating your taxes. What happens is that your taxes are first calculated in the traditional way listed above, and at the same time a calculation is being performed for your AMT. After both calculations have been completed, the IRS looks at which method would lead to you paying the highest amount in taxes. They then make you pay the higher number. For example, if you calculate your taxes the traditional way and it's determined that you would owe $5,000 in taxes, but the AMT calculation leads to you paying $10,000 in taxes, you would owe $10,000.
Is the Alternative Minimum Tax More Restrictive Than The Traditional Tax Code?
Absolutely. Remember that the AMT was created in part to restrict the amount of deductions and credits that wealthy individuals used to reduce their taxable income. The way they do this is by forcing you to add some of the deductions and credits used under the traditional tax code back onto your taxable income before calculating your AMT. The standard deduction, for example, is not allowed in AMT calculations and is added back onto your taxable income. Deductions taken under the traditional tax code for state, local and foreign taxes paid are also not allowed under AMT. Even some deductions that are allowed are given a higher barrier to entry under AMT: under the traditional tax code, medical expenses that exceed 7.5% of your Adjusted Gross Income can be used as a tax deduction; under the AMT code, only expenses exceeding 10% of AGI can be deducted.
Now even though the AMT code method of calculating taxes is much less forgiving, that doesn't mean you're guaranteed to get hammered by the amount you owe in Alternative Minimum Tax. Thankfully, there are three levels of the AMT Tax Code that can be used to reduce your odds of being heavily impacted by the AMT
Level 1: The Exemption Level (26% Tax)
To ensure that only high-income taxpayers are subjected to the AMT, the IRS offers an exemption for the first portion of your income. In 2020, the exemption amount for single taxpayers is the first $72,900 of income, and $113,400 for married couples filing jointly. Going back to our original example of a single person earning $100,000, the AMT exemption means the first $72,900 of their income is exempt, and only the remaining $27,100 of their pay is subject to the AMT calculation. This number - the amount of income exceeding the exemption - is referred to as the Alternative Minimum Taxable Income (AMTI). Once they've exceed the exemption, all their income from now until Level 2 will be taxed at a flat AMT rate of 26%. Once they reach Level 2, however, things change.
Level 2: The 28% Tax
Once you reach a certain level of AMTI, everything exceeding this amount is taxed at a higher rate of 28%. In 2020, the 28% taxation level begins for AMTI that exceeds $98,950 for single taxpayers and $197,900 for married couples filing jointly. Later, we'll look at an example of a person earning a much higher amount of income to see how the two tax rates are applied. For now, let's head to the third level.
Level 3: The Exemption Phase-Out
Once your Alternative Minimum Taxable Income reaches Level 3, your ability to use the AMT Exemption starts to "phase out" or reduce. In fact, the amount of exemption you can use reduces by $1 for every $4 you earn over the Phase-Out threshold. In 2020, the exemption Phase-Out for single filers is $518,400 of AMTI and $1,036,800 for married couples filing jointly. Once taxpayers have AMTI that exceeds these levels, the income exempted from their AMT calculation starts to reduce. If their AMTI reaches a level high enough, they could reach the point where their exemption is eliminated. Now you can see that it would take an extremely high-earner to be the slightest bit worried about reaching this level, but that is exactly who the AMT is designed to impact.
The Final Calculation:
After determining how much taxes a person owes under the AMT calculation, it will then be compared to the taxes they would owe under the traditional tax code. Whichever amount is larger, that is what the taxpayer will pay for the year.
To drive home this lesson, let's use an example of a high income-earner who would be subject to the AMT, so you can see how each Level is applied:
Jane Doe (Single)
Alternative Minimum Taxable Income: $618,400
Taxes owed under traditional tax code: $100,000
AMT Exemption before phase-out: $72,900
Let's look at how Jane Doe is impacted by each level of AMT
Level 1: The Exemption Level (26% Tax)
During this level, Jane Doe can exclude the first $72,900 of her income from being used to calculate her AMT burden. The income that exceeds this amount - her Alternative Minimum Taxable Income (AMTI) - will be taxed at a rate of 26% until it reaches Level 2. As a single taxpayer, Jane will see the first $98,950 of her AMTI taxed at 26%.
Level 2: The 28% Tax
In this level, Jane's AMTI exceeding $98,950 will be taxed at a rate of 28%. At this point, Jane has over $500,000 of AMTI that exceeds $98,950, so she will have the overwhelming majority taxed at 28%
Level 3: The Exemption Phase-Out
At this level, the IRS will look at the amount of Jane's AMTI that exceeds $518,400. For every $4 of AMTI she has above this level, the amount of income she can exempt from her AMT calculation will be reduced by $1. Since Jane's AMTI is $100,000 over the $518,400 threshold, she will see the amount of her exempted income under AMT reduced by $25,000 ($100,000 / 4 = $25,000). This drops the income she can exempt from $72,900 to $47,900.
The Final Calculation
Now the IRS can determine the full amount Jane would owe under the AMT code so that it can be compared to the $100,000 she owes under the traditional tax code. Let's assume that when completing this calculation, it's found that she owes $125,000 under the AMT calculation. Since this amount is higher than what is owed under the traditional tax code, Jane must pay $125,000 in taxes.
That was a lot! And very complex! But the Alternative Minimum Tax is a very complicated thing. Believe it or not, there's a ton of information we didn't cover about all the things that are and aren't allowed when calculating AMT. But hopefully you now have a grasp of the concept and how AMT is used to ensure that high income-earners cannot avoid paying a certain minimum amount of taxes.
Neither Royal Alliance Associates, Inc., nor its registered representatives, or employees, provide tax or legal advice. As with all matters of a tax or legal nature, you should consult with your own tax or legal counsel for advice.