|Kiplinger.com, Fall, 2018. This article was written with Brian Vnak, the Vice President of Advisory Services at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Kiplinger negotiated by me to designate Mr. Vnak as a contributor and to deliver original articles for them on a regular basis.|
Taxpayers are getting an eight-year break for the dreaded Alternative Minimum Tax. Here’s how to make the most of that time.
I would love to have written “peace,” but there is nothing peaceful about the Alternative Minimum Tax (AMT).
Who’s Likely to Be Subject to AMT Going Forward
While the AMT was technically not eliminated from the tax code, for practical purposes it was for the majority of taxpayers. If you were subject to AMT in 2017, you will most likely not be subject to it in 2018. Let’s look a bit deeper across three cases where a married taxpayer lives in a high-tax state and reports $300,000, $400,000 and $600,000 of income. Let’s also assume this taxpayer claims itemized deductions of their state income taxes plus $5,000 in real estate taxes. The results are summarized in the table below.
AMT Case Studies Summary
|Case #1||Case #2||Case #3|
|Ordinary Income |
(wages, social security, pensions, IRA distributions, etc.)
|Dividends/Long-Term Capital Gains||$200,000||$200,000||$200,000||$200,000||$400,000||$400,000|
|Adjusted Gross Income||$300,000||$300,000||$400,000||$400,000||$600,000||$600,000|
|Federal Tax (Regular + AMT)||$44,648||$40,459||$81,272||$66,519||$129,648||$108,969|
|AMT Included Above||$2,946||$-||$12,074||$-||$22,572||$-|
|% decrease in Federal Tax||9%||18%||16%|
|Marginal Rate – Federal||26%||12%||26%||24%||28%||24%|
|Effective Rate – Federal||16%||15%||22%||18%||23%||19%|
In all cases, the taxpayer stopped paying AMT in 2018. This contributed to a reduction in the federal tax liability by 9% to 18% across the cases, even though the taxpayer ended up claiming less deductions (standard in 2018 vs. itemized in 2017). Most importantly, however, is that marginal rates decreased, making 2018 and future years a great time to potentially reduce or eliminate taxes from your retirement.
Despite these changes, a few taxpayers will still find the AMT to be part of their financial life. The most common will be:
- individuals who exercise Incentive Stock Options (ISOs)
- oil and gas investors who have depletion and intangible drilling costs
- investors owning private activity bonds
- and business owners with assets having different depreciation lives for regular versus AMT purposes
Some Possible Investment Moves to Consider
As part of a comprehensive review of how the TCJA impacts your personal situation, the structure of your investment portfolio should not be left behind. With regard to the equity portion of your portfolio, investors will want to re-evaluate the types of securities they own. Tax-efficient investors typically want to control and minimize the amount of capital gains realized each year. For individuals previously vulnerable to AMT, this was critical. Now that this is a much less likely to occur, investors should evaluate if different security types provide economic benefits that generate better after-tax returns.
With regard to the fixed-income portion of your portfolio, investors will want to re-evaluate their ownership of tax-exempt vs. taxable bonds. Many investors subject to AMT owned tax-exempt bonds to avoid the AMT exemption phase-out that occurs when interest income from taxable bonds is earned. Since there is now more capacity for taxable interest before AMT would apply, taxpayers will want to understand their after-tax rate of return on income investments as the spread between tax-exempt and taxable bonds may have closed considerably. Additionally, many investors subject to AMT also avoided owning Private Activity Bonds (PAB) as they were an AMT add back. They still are, but given the larger AMT exemption and high income phase-outs, investors will now likely have more capacity for owning these bonds before becoming subject to AMT.
It Could be Time to Restructure Fee Arrangements with Your IRAs
Many investors purposely paid the fee of their traditional and Roth IRAs out of a non-qualified investment account in order to maximize the income tax deduction for investment management fees. To the extent this amount, plus the other miscellaneous deductions exceeded 2% of AGI, the individual would have received a financial benefit, but only up until this deduction made the individual subject to AMT. Now that this deduction is no longer allowed, investors will want to evaluate the account(s) from which their investment fees are paid to optimize the tax benefits afforded these accounts. In most cases, investors will want to pay their traditional IRA fee out of their traditional IRA instead of the non-qualified investment account.
Will AMT Become Frankenstein Again?
As was previously noted, the AMT relief provided by the new tax law is temporary, with a scheduled termination date of Dec. 31, 2025. Consequently, if Congress does nothing, the AMT will resuscitate itself and live to terrorize another day. In the meantime, let’s enjoy this eight-year vacation from AMT and make a point to take advantage of the potential opportunities that exist.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal adviser.