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The alternative minimum tax (AMT) is pesky. You think you’re done with your tax return, only to do the calculations for the AMT and find that you owe more taxes. While it was designed to catch wealthy tax avoiders, the AMT may unwittingly snare many others in the middle class these days.
Here’s what the AMT is and six ways to reduce (and maybe eliminate) your AMT bill.
What is the alternative minimum tax and how does it work?
The AMT was created in 1969 to make sure that wealthy taxpayers weren’t abusing loopholes and workarounds to avoid paying tax. To do so, the AMT creates an entirely new way to figure your taxes, limiting certain deductions and other means to reduce your income. Even AMT tax rates are different from the standard income taxes, and are figured at either 26 or 28 percent.
“The AMT is effectively a secondary tax that needs to be calculated every year you file taxes,” says Vieje Piauwasdy, director of equity advisory at Secfi, a fintech company in San Francisco. “But due to the AMT rules, the vast majority of Americans do not pay AMT.”
Those most likely to be hit? “High-income families whose taxable income exceeds $1 million,” says Jeffrey Lewis, a financial adviser with Savant Wealth Management in the Rockford, Illinois area. But he says you might still get hit with the AMT even with as little as $200,000 in income, depending on the type of income and deductions you take.
If you’re taking a lot of itemized deductions on Schedule A, you might trigger the AMT, depending on the type of deductions. Also a frequent target: executives who exercise and hold incentive stock options.
After they calculate their taxes twice, taxpayers are forced to pay whichever amount is higher. But there are ways to reduce your tax liability under the AMT rules, and they can be valuable if you’re on the hook for the tax or think you might be in any given year.
Even if you’re not subject to AMT, it can make a lot of sense to minimize your tax liability with these unusual last-minute moves.
6 ways to reduce your AMT
Here are six strategies to help you reduce or even eliminate your AMT.
1. Defer income to next year
If your income is lumpy or you have some ability to control when you’re paid – perhaps if you’re a freelancer – you may be able to optimize your tax situation by pushing income into next year. Also try deferring any bonus payments, which may have more flexibility than regular income.
By reducing your adjusted gross income, you may be able to avoid the AMT entirely.
2. Contribute to your 401(k) or 403(b)
If you contribute to a traditional 401(k) or 403(b) plan, you’re saving for retirement with pre-tax dollars, so it’s as if that money comes right off the top of your income, reducing your total taxable income. That’s great news for reducing or eliminating your AMT liability. You can do the same with a SIMPLE IRA, too.
The maximum annual contribution to a 401(k) is $19,500 for 2020, but you can also contribute another $6,500 if you’re over age 50, meaning you can really slash your taxable income.
3. Take advantage of a solo 401(k)
If you own your own one-person business (or two-person, if it’s a spouse), open a solo 401(k) and you may be able to put away even more income through its special rules. Not only can you make a contribution as an employee – with the same maximums as a traditional 401(k) plan – but you can also hide away more money as an employer contribution. Your business can contribute up to 25 percent of its profits, up to an additional $37,500 in 2020.
By reducing taxable income through retirement contributions, you’re making two smart moves.
4. Create tax-free income with a Roth IRA
“Those with a large Schedule A deduction or a lot of preferential income, like qualified dividend income, capital gains, or muni bond income, could trigger the AMT,” says Kelly Crane, president and chief investment officer at Napa Valley Wealth Management in St. Helena, California.
His solution? “Create tax-free income by contributing to a Roth IRA or health savings account.”
The Roth IRA is one of the best investing vehicles ever invented because of its ability to shelter income from taxes and then make it completely tax-free when you withdraw it at retirement. You’re still able to generate income, but it will be safely protected from taxes inside the IRA.
You may be able to move some of your income-generating assets inside the Roth or roll over a retirement plan into a Roth IRA. Higher earners may have to use a backdoor Roth IRA.
5. Give to charity
Giving to charity can make you feel good, and Lewis suggests it’s a great option for beating the tax man, too. He mentions donor-advised funds, cash donations and charitable trusts as avenues for giving – though he advises that “all should be vetted before simply writing a check.”
Some moves such as a donor-advised fund actually help you bunch your contributions into one year, offsetting more income that year, even if you don’t distribute the money until a later year.
6. Move deductions to a different schedule
Crane suggests moving any possible deductions to Schedule C (for businesses or sole proprietors) or Schedule E (for rentals, royalties, partnerships and others). Of course, this move only works if you have a business, rentals or other income that fits those categories.
But many higher-earning individuals do have their own business or a sideline for income where it makes sense.
The AMT can be complicated and it adds further complexity to a tax code that can already feel maze-like. In these situations it may be helpful to call in a tax preparer to figure out your tax situation, and such skilled preparers may well save you much more than it costs to hire them.