Friday, April 11, 2014

Understanding the AMT

During tax time, using regular IRS rules you start with your gross income, subtract deductions and exemptions and eventually you arrive at your taxable income amount. Sounds simple unless your income is too high and you take too many deductions. Enter the Alternative Minimum Tax.

The Alternative Minimum Tax (AMT) is basically a simple flat tax system, the rate is 26 percent on the first $175,000 of income and 28 percent on anything above. You add up all your income, subtract the few allowable deductions, deduct the AMT exemption - which makes up for all the other forgone deductions - and viola you arrive at your taxable income. When you think about it, it really is much simpler than the current system in place.

But the reality is if you are exposed to the AMT you need to calculate your taxes under both the regular system then back out AMT adjustments and preference items, apply the AMT exemption, careful to note phase outs, and calculate your second tax liability. You end up paying the larger of the two.

When figuring AMT, even though some deductions still stand, including those for mortgage-interest and charitable donations, some key breaks are lost. They include: state and local income taxes and property taxes, child-tax credits and home-equity loan interest.

Everyone who files taxes is obligated to figure out whether they have to pay AMT (see line 45 on the 1040). The worksheet and Form 6251 can be difficult and time consuming which is why a significant majority of AMT payers hire a CPA professional. The first time most people hear about the Alternative Minimum Tax is when they get a letter from the IRS saying that they still owe money. To avoid this, check out "AMT Assistant," an online tool offered by the IRS that helps you determine whether you need to pay the AMT – if you decide to DIY.

There are some AMT planning strategies that should be examined to minimize your tax burden. Michael Kitces a CFP® and blogger who is well respected in the industry, noted in a recent blog post:
Under the regular tax system, good tax planning is relatively straightforward – since tax brackets just rise as income increases, the goal is to defer income when income is high (and the tax brackets will be high), and accelerate income when income is low (e.g., harvest it in the form of capital gains or Roth conversions, to avoid having too much income that drives the client into higher brackets in the future).

With the AMT, though, planning is different. In the case of the AMT, the system is a (relatively) flat tax system with only two brackets of 26% and 28%. Accelerating income isn’t necessarily helpful, and deferring income isn’t necessarily harmful, as the tax rates hardly vary anyway. However, one important nuance of the AMT system is that, as income rises, the large AMT exemption that “everyone” gets is itself phased out. Once the phaseout threshold is reached (at $117,300 for individuals and $156,500 for married couples, indexed annually for inflation), every additional $1 of income also phases out $0.25 of the exemption, which at a 26% - 28% tax rate is actually the equivalent of a 6.5% - 7.0% “surtax”.

As a result, taxpayers who are phasing out their AMT exemption actually face a “bump zone” of tax rates, as their AMT marginal tax rate jumps up to 32.5% and then 35%, before ultimately falling “back” down to 28% once the AMT exemption is fully phased out!

Given this unusual “bump” in marginal tax rates in the middle, AMT tax planning takes on a rather unique approach – simply put, the goal is to “avoid the bump” to the extent possible. If income is low, this means the best approach is to spread out or defer income, stay below the bump zone. However, if income is high, the best approach may actually be to accelerate income to avoid the bump zone in the future, since the top AMT rate remains ‘capped’ at maximum rate of only 28% (and 20% + 3.8% = 23.8% for capital gains at those income levels) once the exemption is phased out.

So as you prepare your taxes (or have then prepared) be on the lookout if your deductions and exemptions under the normal code are close the AMT exemption and also if your adjusted gross income changes significantly due to itemized deductions and exemptions. And as always, when in doubt, contact a certified professional.


CBlakely, CFP®    04/2014

Sources: NY Times, IRS, NerdsEyeView blog

Wednesday, January 29, 2014

The Back-Door IRA Strategy

The back-door IRA is, if done properly, a “contribute and convert” strategy. There are income limits on Roth IRA contributions (currently AGI of $188,000 or greater for couples filing jointly). However, there are no adjusted gross income limits on Roth IRA conversions. So as an investor you might have income that doesn’t qualify for direct Roth contributions but since there are no income limits on a traditional IRA you can still contribute to a non-deductible traditional IRA and then convert it to a Roth IRA. With this back-door Roth feature, what investors could do is contribute toward a traditional IRA and then quickly, convert it to a Roth IRA. This two-step process allows high-income earners to participate in the benefits of a Roth IRA (assuming this is a strategy the investor is interested in pursuing).

Two important considerations:

First, do the conversion quickly after the original contribution is made so that the account doesn’t accumulate any earnings, if it does, the rollover triggers income tax only on the appreciation of the after-tax contributions, which would likely be negligible. Repeat the technique each year using the same traditional IRA and Roth IRA.

Second, if you have other traditional IRAs that will not be converted, the IRS requires you to aggregate all of those IRAs, so this could potentially be a taxable event. This is due to the "pro-rata" rule, requiring investors with pre-tax contributions in a traditional IRA as well as nondeductible IRA contributions to divide the value of their nondeductible contributions by their aggregate IRA assets to determine what percentage can be converted tax-free. Which is why this technique works best for younger professionals with high incomes that don't already have a large amount of savings in a traditional IRA’s.


One advantage of this strategy is drawing from a Roth IRA will help reduce the income taxes owed in retirement when you begin taking distributions. When the conditions are right, this is a practical solution for investors who want to maximize their retirement earnings and retirement cash-flow.

As always, remember that all investing is subject to risk so it is wise to consult an accredited professional before making investment decisions.

CBlakely  CFP®                          01/2014