Tax on rich may snag you

How to avoid being a target of alternative minimum tax

Your Money

November 27, 2005|By GAIL MARKSJARVIS | GAIL MARKSJARVIS,CHICAGO TRIBUNE

You may not live the life of the rich and famous, but when Uncle Sam taxes you, he may treat you as though you do.

The alternative minimum tax, designed more than three decades ago to catch the cagiest of rich tax evaders who used clever deductions to eliminate their income tax, is becoming the feared tax of the middle class. Typically, people with incomes between $150,000 and $300,000 are most vulnerable to the AMT, but sometimes people with moderate incomes get nabbed - especially single parents with many dependents and deductions, salespeople with a lot of unreimbursed business expenses, or investors with certain bonds or other investment gains.

Almost 4 million of the nation's 131 million taxpayers are expected to pay the AMT this year. About 2 percent will have adjusted gross income between $75,000 and $100,000. But because the AMT is anticipated to snare many more middle-income families in the future, a bipartisan tax-reform panel has urged the government to dump it. If it remains, it is expected to affect about 31 million taxpayers by 2010.

The AMT isn't based on income levels alone. Much has to do with the combination of taxpayers' income and the deductions, credits and exemptions they take. So a person with high income, but few miscellaneous deductions compared with their income, might escape the AMT. Yet a person with modest income but a lot of deductions is vulnerable.

Although AMT calculations are nearly impossible to predict, the original intent helps make the concept understandable. The AMT was created to catch rich people who used clever deductions to eliminate their income tax. Now, however, as incomes and costs of everything from travel to property taxes have climbed, average people can become stuck.

For example, when people calculate their federal income taxes, they are allowed to deduct the state and local taxes. But a person who does that in a high-tax state like California or New York will have such a large deduction on their federal return, it could throw them into the AMT.

It comes down to this: Deductions help you reduce your taxes when you calculate your federal income taxes with the traditional formula. But the process for the AMT is the opposite: You must add deductions back to your income - often giving you higher taxes than expected.

When you do your tax return, you will be required to figure your taxes with two separate rulebooks - one for traditional taxes, and the other for AMT. If the AMT method gives you higher taxes, you will be stuck.

Because the AMT is so quirky, "it rears its ugly head where you don't expect it," said Linda Forman, a certified public accountant in Evanston, Ill.

She has a client who sold $1.6 million in property and avoided the AMT. Another, with a $500,000 income, paid no AMT. Yet a divorced mother of four fell within the AMT despite an income less than $100,000. She had to pay $3,600 more in taxes than she would have without the AMT, because she deducted $15,000 in legal and accounting costs from her divorce.

In situations such as that, there is not much that an accountant can do at the last minute to change the results.

For example, Naperville, Ill., certified public accountant Ann Marie Craighead has a client who makes only $15,000 on her job, but fell within the AMT last year. The culprit: the fund set up to provide her income when she was divorced. Her broker sells stocks in the fund, and when he does she incurs a capital gain, that lifts her income. It was too late to save her last year - she had to pay $22,500 in taxes, instead of only $11,000 with traditional tax calculations - but this year Craighead is identifying losing investments to reduce the impact of the AMT.

Although capital gains and losses can affect the AMT, tax experts warn people against taking knee-jerk reactions with their investments to ward off the tax because a transaction could aggravate, rather than improve, the tax outcome.

So they suggest running AMT calculations using the Internet. "As you do the calculation, do `what ifs,'" said Rande Spiegelman, vice president of financial planning for Charles Schwab. "What if I took a capital gain of $20,000? What if I took a loss to offset it? What if I made a charitable contribution?"

Although most typical deductions can't be used to reduce the AMT, charitable contributions are allowed and consequently may help cut the tax.

A person who is in the practice of giving a contribution every year to an institution such as a church could make a particularly large contribution in a single year to avoid the AMT, and tell the institution it was a multiyear contribution.

Another alternative: Put money into a "charitable gift fund" offered by firms such as Schwab and Fidelity. Once the money is in them, you can deduct it as a contribution that year, but take years to distribute it to charities of your choice.

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