Understanding the Alternative Minimum Tax

As if figuring your taxes once wasn't complicated enough, the IRS makes you run another set of numbers with the alternative minimum tax (AMT).

You could call it the Aggravating Monumental Tax, Accelerating Misery Tax, or even the Agony Most Troubling. The alternative minimum tax (AMT) has taxpayers holding their breath as they calculate their tax bill not once, but twice.

Addressing more taxpayers

The AMT is a secondary tax system that was initially designed to keep rich folks from using exemptions and deductions to whittle their tax liability down to nothing. The trouble is, you no longer have to be particularly wealthy to get hit with the AMT. Since its provisions aren't adjusted for inflation, it's becoming increasingly easy to slip into its territory. Some estimates predict that the AMT will dig its claws into as many as one-third of all taxpayers by 2010.

Mystifying technique

Here's the high-level overview on how the AMT works. Once you calculate your taxes the regular way, you're then tasked with re-calculating them the AMT way. To do this, you must add back various items to your adjusted gross income (AGI). These include income earned from private activity bonds, as well as three different types of deductions: personal exemptions, dependent exemptions, and the standard deduction, if you don't itemize. The AMT also doesn't allow you to deduct expenses for investment, business, and some medical, as well as home equity interest on debt that isn't used to improve your home.

The AMT system treats incentive stock options (ISOs) differently, as well. If you exercise your ISOs, the difference between the strike price and the trading price of that stock on the exercise date is considered income-even if you still own the stock and its market value subsequently drops. There's a small consolation here, however. Your new cost basis on the stock will be the trading price at the time you exercised the options, which keeps you from getting double-taxed on the capital gains once you sell.

The full list of AMT calculations are provided on Form 6251. After agonizing through the form on your own or with your tax advisor, you'll arrive at an AMT taxable income figure. From here, all you do is subtract the appropriate AMT exemption amount. For 2008, these figures are:

• Married filing jointly and qualifying widower: $45,000, reduced by 25 percent of AMT income above $150,000
• Single and head of household: $33,750, reduced by 25 percent of AMT income beyond $112,500
• Married filing separately: $22,500, reduced by 25 percent of AMT income in excess of $75,000

The amount left after you subtract your exemption is taxed as follows: 26 percent on the first $175,000 (or $87,500 for married filing separately) and 28 percent on everything else. If the resulting tax is greater than your regular income tax amount, you'll pay the difference-in addition to your regular tax. This is exactly where the Agony Most Troubling sets in. Please consult your tax advisor to fully understand if the alternative minimum tax affects you.