Recently, I found myself in the middle of an unusual conversation with my daughter. I use the word “unusual” because it’s definitely not what I’m used to. As a parent, I’ve spent years responding to softball questions that I don’t have to think anymore. “Can I punch my sister? No.” “Can I stay up late? No.” “Can I punch my sister and then stay up late? No.” In fact, I’ve gotten to the point that I can literally answer 99% of my kids’ questions while in a deep sleep, and often do. My method is simple. I just answer “No” most of the time and throw in a sporadic “Yes” once in a while to keep everyone on their toes. So I was completely unprepared when out of nowhere my daughter asked me, “Why do bad things happen to people sometimes?”
This is not what I was trained for. Before this, the most challenging question I’ve dealt with involved the permissibility of snacks, and now I found myself in a philosophical discussion on the manifestation of evil in the universe. I began to panic. My initial response was, “Don’t hit your sister” but that turned out to make no sense at all. All my training failed me and I was left to fend for myself. Eventually, I replied that there are just some bad things in life that we can’t control and don’t always understand. This is exactly how most people feel about the AMT tax as well – it’s awful, it seems to make little sense, and there’s very little we can do about it besides accepting our fate.
The AMT tax, which is short for alternative minimum tax, is basically a separate, parallel tax calculation that you are required to calculate in addition to your regular income tax calculation. You may not have heard of it, even if you pay it, because it’s really just another calculation that your accountant does on the regular tax form. So you have two tax calculations—the regular income tax and the AMT—and then you pay whichever one is higher. The alternative minimum tax on line 45 of your 1040 is really just the difference between what you would owe under the regular tax calculation and what you would owe under the AMT. If the regular tax bill is higher, that line is zero. If the AMT tax bill is higher, then line 45 is the difference between your tax bills under the two systems. (If you fell asleep four sentences ago, don’t worry, your accountant will do the calculation anyway).
Lawmakers implemented the AMT in 1969 because 155 high income taxpayers that claimed a lot of (legal) deductions owed no tax that year. So just to get this perfectly straight—the government didn’t get money from 155 people out of hundreds of millions of taxpayers one year and did what every rational human being would do and started a whole new tax system that now effects over 15% of the U.S. population and will cost taxpayers $385 billion over the next decade. Thank you Congress and thank you 155 taxpayers in 1969 for ruining it for everyone.
The problem is while the AMT tax was designed to make things fair by taxing the rich that were able to get away with a relatively small tax bill, it turns out that the demographic most-often hit with this tax is the middle class. That’s because high income taxpayers often pay income tax at the highest tax rate already (39.6% in 2015), so computing the tax under the AMT calculation (highest AMT rate is 28%), will often result in a smaller tax liability than their regular tax. However, this is not always the case with middle class taxpayers that pay at a lower tax rate.
So you may not be able to do much to avoid the AMT tax, but who tends to be most susceptible to this tax? Besides for your income being high enough (say $250,000 or more), there are some other critical factors, of which I will mention a few:
- Large families: Under the regular tax calculation, you get a generous tax break for each member of your family. For every family member you claim on your tax return you get to exclude up to $4,000 of income from your taxable income. So if you have five, six, or a baker’s dozen of kids then that can be a nice tax break. However, the AMT doesn’t allow for this tax break so while your regular tax calculation may result in a minimal tax liability, your AMT tax calculation can result in a hefty tax bill. As I said, there’s not much you can do about this—if your tuition bills haven’t stopped you from having kids at this point then I doubt the AMT tax will.
- High Property Taxes: The only good thing about paying high property taxes in New Jersey is that you can deduct it on your tax return. However, for AMT purposes you can’t deduct any property taxes or even the state and local income taxes you pay each paycheck.
- Employee Business Expenses: If your job requires you to incur a fair amount of expenses that your employer does not reimburse you for, then you can deduct these as Miscellaneous Itemized Deductions. This is very helpful to certain professionals, such as real estate brokers and those in sales. However, the AMT strikes again and disallows Miscellaneous Itemized Deductions to be deducted in the calculation.
So why does the AMT tax happen to good people? There are just some things in life we don’t understand…but it may have something to do with the billions of dollars the government rakes in every year.