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Your Bank > Education and Advice > CNB University

Beware of the AMT

James P. Terwilliger
James P. Terwilliger, PhD, CFP® is Senior Vice President - Group Manager, Financial Planning Strategies and can be reached at JTerwilliger@CNBank.com or (585) 419-0670 x50630.

Beware of the AMT. No, I am not referring to your favorite cash machine. AMT is shorthand for Alternative Minimum Tax - the so-called "quot;stealth"quot; tax that more and more taxpayers will get to know over the next few years.

In 1969, Congress came up with the idea of an alternate tax as a way to prevent the very wealthy from using loopholes to avoid paying regular income tax. It created a parallel method for calculating taxes. This method ignores most itemized deductions, personal exemptions, and tax credits.

The tax is based on a flat 26%-28% of alternative minimum taxable income which is generally adjusted gross income offset by a few deductions (charitable contributions and home mortgage interest are two) and a standard exemption of $58,000 for married taxpayers filing jointly (reduced to $45,000 after the 2004 tax year). This exemption phases out at higher incomes. The calculation can be much more complicated, although the above demonstrates the general idea.

Taxpayers are required to determine their taxes using both methods - the regular method and the AMT method. If the AMT calculation (using Form 6251) results in a higher tax compared to the regular tax calculation, the difference is added to the regular income tax on Form 1040. In effect, the taxpayer is liable for either the AMT or regular income tax, whichever is higher.

Good idea - The wealthy need to pay their fair share. Bad execution - Rapidly growing numbers of taxpayers, the middle class, are beginning to find themselves defined as "quot;wealthy"quot; at least according to the AMT formula.

AMT now hits 3 million taxpayers and threatens 30 million more (about one in three) over the next seven years. Among them will be one-third of households with adjusted gross incomes of $50,000 to $75,000 and three-quarters with adjusted gross incomes of $75,000 to $100,000.

As it takes over the tax code, the AMT will effectively repeal much of the Bush tax cuts. A major fix would cost the US Treasury upwards of $1 trillion. With record federal deficits and no apparent end in sight, there is virtually no support from Congress or the administration for any adjustment, let alone major overhaul, of the AMT.

How did we get into this growing AMT predicament?

First, the AMT formulas have remained virtually unchanged since they were enacted in 1969. (One exception is the standard exemption amount which was temporarily increased for the 2002-2004 tax years.) There have been no adjustments for inflation over that timeframe. Any such adjustments would have been beneficial to taxpayers.

Conversely, our regular tax method has seen beneficial annual adjustments for inflation and two sweeping federal tax cut bills of 2001 and 2003 that resulted, for most taxpayers, in measurably lower regular federal income taxes.

The result is inevitable. Taxes calculated using the regular method are decreasing. Taxes calculated using the AMT method, associated with rising incomes, are increasing. When the two lines cross, which is the case for more and more folks, the AMT method wins out.

What might drive you into AMT territory?

New federal long-term capital gains rates - The lower rates have prompted some taxpayers to sell off quantities of appreciated stocks. But, with the gains driving up adjusted gross income to a level at which the AMT exemption amount is partially or fully phased out, the resulting additional tax can easily end up being several thousand dollars.

Exercise of incentive stock options (ISOs) - If exercised stock is held beyond the end of the calendar year of exercise, there is no realized income for regular tax purposes. But AMT counts the bargain element at the time of exercise as income for AMT purposes. The result is an additional tax on unrealized paper profits. Some of this additional tax may be recovered as an AMT credit in future years, but only if the taxpayer is normally not in AMT country.

Other "quot;risk"quot; factors - Living in a high state-income-tax state, such as New York, where state tax deductions are not allowed in the AMT calculation; having a large family, since personal exemptions are not allowed; paying interest on home equity loans if the loans are not used to improve your home, since these interest deductions are not allowed; and the list goes on.

Are you or will you be impacted? Only your tax preparer knows for sure! Be sure to consult with your tax and financial planning professionals to understand where you are and what your options might be. This is an area ripe for making well-informed tax planning decisions.

James Terwilliger, Certified Financial Planner™, is Vice President, Financial Planning, Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext 50630 or by email at jterwilliger@cnbank.com.