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Middle-class taxpayers caught in tax trap

All set to enjoy your cut of the latest tax breaks?

Don't spend it too fast. If your taxable income and deductions meet certain criteria, you may lose that tax break and likely pay even more, thanks to a little known but increasingly worrisome "stealth tax" called the individual alternative minimum tax, or AMT.

As its name suggests, the AMT is a separate, but parallel, tax system that operates alongside the one we're used to wrestling with. The AMT imposes a flat tax of 26 percent to 28 percent. That doesn't sound so bad when you consider that the regular tax system has two higher rates, 33 percent and 35 percent.

The notoriously complex AMT, however, was designed to make sure that the wealthy paid their fair share of taxes. To that end, it has different definitions of income and allows fewer deductions. When all the calculations are complete, it produces a higher tax bill than does the regular tax system -- and the affected taxpayer must pay the larger amount.

And it's no longer just the affluent who are paying AMT. A growing number of not-so-wealthy taxpayers are discovering that they, too, are hit with this higher tax.

So what can you do to beat this extra tax burden? Unfortunately, not much. Because of its peculiarities, this parallel tax defies most traditional tax planning.

The best hope now for taxpayers is to convince lawmakers that changes need to be made to the AMT. Politicians normally might be receptive to the argument that the AMT burden is now falling on people for whom it was not meant. But the plea for AMT relief is complicated by the fact that regular tax-rate cuts have made the federal treasury more dependent on the alternative tax revenue.

While the tax debate continues, and to keep you from being blindsided by the tax, here's a look at the AMT's history and how you could fall into its clutches.

Why AMT?
Congress created the alternative tax in 1969 in the wake of testimony by Treasury Secretary Joseph Barr that 155 high-income households had paid zero tax in 1966.

Unfortunately, the lawmakers failed to index the AMT for inflation. As a result, the tax patch originally designed to target wealthy tax dodgers now is increasingly hitting unwitting middle-income households. If you have a large family, incentive stock options or live in states such as New York or California where state taxes are high, you may well be blindsided soon.

"A few years ago, we started seeing people with very large families getting hit with this tax. That was kind of the canary in the coal mine," says Beth Kern, associate professor of accounting at Indiana University.

"Now it's to the point that if you have four kids, it will eventually come to your door. When you look at the actual numbers and estimates that are coming out, it's phenomenal what is going to happen in the next couple years. It's on the way."

Scary scenarios
Got your attention? Now get ready for the scary figures.

William Gale, deputy director and senior fellow of economic studies at the nonpartisan Urban-Brookings Tax Policy Center, says that under current law, AMT coverage will skyrocket. In 1999, a million filers faced the AMT. By 2010, the tax will hit 33 million taxpayers, about one-third of all returns. The U.S. Treasury Department released figures on April 2 that project more than 46 million filers will pay AMT in 2014.

 
 
Next page: Why don't we get rid of it?
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