The alternative minimum tax (AMT) is a hassle. You think you have completed your tax return, only to do the AMT calculations and find that you owe more taxes. Although it was designed to catch the wealthy tax avoiders, the AMT can unintentionally trap many others in the middle class these days.
Here’s what AMT is and six ways to lower (and possibly eliminate) your AMT bill.
What is Alternative Minimum Tax and How Does It Work?
The AMT was created in 1969 to ensure that wealthy taxpayers did not abuse loopholes and workarounds to avoid paying taxes. To do this, the AMT creates a whole new way of calculating your taxes, limiting certain deductions and other ways to reduce your income. Even the AMT tax rates are different from standard income taxes and are estimated at 26 or 28 percent.
“The AMT is actually a secondary tax that has to be calculated every tax year,” says Vieje Piauwasdy, director of equity advice at Secfi, a financial technology company in San Francisco. “But because of the AMT rules, the vast majority of Americans don’t pay AMT.”
Who is most likely to be affected? âHigh income families with taxable income over $ 1 million,â says Jeffrey Lewis, financial advisor at Savant Wealth Management in the Rockford, Illinois area. But he says you could still be affected by AMT even with income as low as $ 200,000, depending on the type of income and the deductions you take.
If you take a lot of itemized deductions on Schedule A, you could trigger the AMT, depending on the type of deductions. Also a frequent target: executives who exercise and hold incentive stock options.
After calculating their taxes twice, taxpayers are forced to pay the higher amount. But there are ways to reduce your tax liability under the AMT rules, and they can be useful if you are or think you are subject to tax in a given year.
Even if you are not subject to the AMT, it can be a good idea to minimize your tax payable with these unusual last minute measures.
6 ways to lower your AMT
Here are six strategies to help you reduce or even eliminate your AMT.
1. Postpone income until next year
If your income is a lump sum or you have some ability to control when you get paid – perhaps if you are a freelance writer – you may be able to optimize your tax situation by carrying your income forward to next year. Also, try to postpone any bonus payments, which may have more flexibility than regular income.
By reducing your adjusted gross income, you may be able to avoid AMT altogether.
2. Contribute to your 401 (k) or 403 (b)
If you contribute to a traditional 401 (k) or 403 (b) plan, you are saving for retirement with pre-tax dollars, so it is as if that money is coming directly on top of your income, reducing your total taxable income. . This is great news for reducing or eliminating your AMT liability. You can also do the same with a SINGLE IRA.
The maximum annual contribution to a 401 (k) is $ 19,500 for 2020, but you can also contribute an additional $ 6,500 if you’re over 50, which means you can really lower your taxable income.
3. Enjoy a 401 (k) solo
If you own your own one-person (or two-person, if it’s a spouse) business, open a 401 (k) solo and you may be able to set aside even more income from its special rules. Not only can you contribute as an employee – with the same maximums as a traditional 401 (k) plan – but you can also hide more money as an employer contribution. Your business can contribute up to 25% of its profits, up to an additional $ 37,500 in 2020.
By reducing taxable income through pension contributions, you are doing two smart things.
4. Create tax-free income with a Roth IRA
“Those with a large Schedule A deduction or many preferential income, such as eligible dividend income, capital gains, or municipal bond income, could trigger the AMT,” Kelly said. Crane, president and chief investment officer at Napa Valley Wealth Management in St. Helena, California.
His solution? âCreate tax-free income by contributing to a Roth IRA or health savings account. “
The Roth IRA is one of the best investment vehicles ever invented because of its ability to protect income from tax and make it completely tax free when you withdraw it in retirement. You are still able to generate income, but it will be safe from taxes inside the IRA.
You may be able to move some of your income-generating assets inside the Roth or transfer a retirement plan to a Roth IRA. High incomes may have to use a Roth IRA backdoor.
5. Donate to charity
Giving to charity can make you feel good, and Lewis suggests it’s a great option for beating the IRS too. He mentions donor-advised funds, cash donations and charitable trusts as ways to give – although he advises that “everything should be checked before you just write a check.”
Some metrics, such as a donor-advised fund, actually help you pool your contributions over one year, offsetting more income that year, even if you don’t distribute the money until a year later.
(Here are some other smart ways to use charitable giving to reduce your tax burden.)
6. Move deductions to another schedule
Crane suggests moving all possible deductions to Schedule C (for businesses or sole proprietors) or Schedule E (for rentals, royalties, partnerships and the like). Of course, this move only works if you have a business, rentals, or other income that fits these categories.
But many people with higher incomes have their own businesses or secondary income where it makes sense.
At the end of the line
AMT can be complicated, and it adds additional complexity to a tax code that can already look like a maze. In these situations, it can be helpful to hire a tax preparer to determine your tax situation, and these skilled preparers just might save you a lot more than it costs to hire them.