Many Marylanders, as well as residents in other high-tax states, may find their savings under the new tax law either shrink or disappear because of a little-known tax that will end up snagging millions more people in years ahead.
The villain: the alternative minimum tax.
Introduced in 1969, the tax is designed to make sure the rich don't avoid paying their share of taxes by making heavy use of deductions and other tax breaks.
But the provision has been increasingly snaring middle-class taxpayers because it has never been adjusted for inflation. And the new tax law signed into law last month by President Bush exacerbates the problem.
Taxpayers pay the alternative minimum tax if they owe more under that provision than under the regular income tax. Generally, the alternative minimum tax hits those with incomes of $100,000 to $500,000, experts said.
The alternative minimum tax formula doesn't permit certain deductions, including personal exemptions for taxpayers and their children as well as deductions for state and local income and property taxes. That's why those who take many deductions can incur the tax.
John Koch, a father of three in Baldwin, said he was surprised when filing his 1999 tax return to find out that his deductions pushed him into the alternative minimum tax.
Koch worked for an insurance company and paid certain work-related expenses out of pocket that he would later deduct on his tax return. But those deductions aren't allowed under alternative minimum tax. So that year, with income less than $150,000, Koch was hit by the tax.
"I was sort of shocked. I never heard of it," the 39- year-old said.
Koch said the tax trimmed his refund by about $2,000. "The refund wasn't as much as it could have been, but I was lucky. I had a friend working at the same company that ended up paying $5,000 or $6,000," he said.
Since then, Koch's business has restructured, and he hasn't paid the tax again.
The new tax law offers temporary relief from the alternative minimum tax by slightly increasing the amount of income exempted from the tax. But that relief vanishes after 2004, just when the brunt of the lower income tax rates begins kicking in.
Because the alternative minimum rates remain unchanged at 26 percent and 28 percent, chances are that more taxpayers will end up owing more under the alternative minimum tax than regular income taxes. And that reduces some of the savings they would have enjoyed under the new tax law.
"Your regular tax rates are going down, so that will help. On the other hand, the AMT tax rate will not go down. So, it's basically giving with one hand and taking away with the other," said Bob Trinz, manager of Research Institute of America, a tax information provider in New York.
Today, 39,000 Marylanders - less than 2 percent of the taxpayers - pay the alternative minimum tax, according to Citizens for Tax Justice, a policy research group in Washington. By 2008, when many of the tax breaks take effect, 290,000 Marylanders will owe the tax, or about 12 percent of taxpayers.
Nationally, 1.4 million taxpayers are affected by the alternative-minimum provision under the new law, according to the Joint Committee on Taxation. In 2010, the last year of the tax cuts, that number is projected to soar to 35.5 million, about double the number that would have been affected under the old law.
"Right now, the only people that want to know about AMT are the ones that are paying it. It's a small segment," said Robert McIntyre, director of Citizens for Tax Justice. "If they don't do something about it in the next few years, you'll have a lot of people with loud voices complaining a lot."
For that very reason, many expect Congress to change the alternative minimum tax.
Marylanders likely will be among those complaining. Taxpayers here will be more affected by the alternative minimum tax than residents of some other states because of Maryland's high taxes that can't be deducted. Marylanders ranked fourth in the country for claiming the highest state and local tax deductions, according to a House Ways and Means Committee analysis.
A spokeswoman for Maryland's Department of Business and Economic Development said the risk of the alternative minimum tax won't dissuade businesses from moving to the state because companies are drawn by the skilled workers, market size and other factors.
The Washington office of accounting firm Deloitte & Toucheanalyzed the tax savings under the new law and found that the alternative minimum tax is one reason why those in high-tax states won't get the full benefit of the tax cuts.
For example, a married couple with two children and income of $150,000 would receive a $985 tax savings under the new law if they lived in a high-tax state and a $3,869 savings if residing in a low-tax state.
Singles earning $75,000 would see a $1,162 tax savings in a high-tax state and a $1,229 savings in a low-tax state.
"The people who would get no savings under the [new law] would be those people who are already paying the alternative minimum tax," said Clint Stretch, director of tax policy at Deloitte & Touche.
Because of the growing alternative minimum tax problem and how it will affect states differently, Congress is expected to permanently fix the tax. It won't be cheap. The loss in tax revenue is estimated to range from $200 billion to $400 billion over 10 years, Stretch said. "This has to be fixed," he said, noting the tax was created to catch abusers. "It's hard to feel you are a tax abuser because you pay California income tax."