The alternative minimum tax (AMT) was created to close loopholes and ensure that all U.S. taxpayers pay their fair share of taxes. When you pay an AMT, some or all of that additional tax is for future income that is being taxed due to differences in the rules. For those payments, a credit is issued that you can then use to cover future tax liabilities. For help designing an appropriate asset allocation and managing your portfolio’s taxes, consider working with a financial advisor.
What Is the Alternative Minimum Tax (AMT)?
The alternative minimum tax (AMT) is a parallel tax system that is designed to catch tax filers who avoid paying taxes on certain parts of their income under the traditional income tax system. It was created in 1969 when 155 people with high incomes used so many tax deductions that they owed nothing in taxes. In general, some non-taxable income is included in AMT calculations, while some deductions are excluded.
The AMT is commonly triggered by high household income, large capital gains and exercising stock options. For example, exercising qualified employee stock options is typically a non-taxable event until the shares are sold. However, this paper profit is considered taxable under AMT calculations. Under the AMT, you may owe taxes on those stock options, even though you haven’t realized the gains yet.
What Is the AMT Credit, and How Does It Work?
The AMT credit is an adjustment that helps reconcile additional taxes paid under the AMT rules versus when the income is normally considered taxable. Affected taxpayers are expected to calculate the AMT credit and carry it forward until it can be used in future years. When the AMT credit becomes usable, it lowers the current year’s taxes owed dollar-for-dollar by the related amounts paid in previous years.
For investors, the AMT often affects the exercise of incentive stock options (ISOs) due to when options are exercised and when the shares are sold. So let’s say you have 100 ISOs available to exercise. The strike price is $2 per share, but the current market price is $22 per share.
When you exercise your 100 options, you now have a cost basis of $200, while the shares have a market value of $2,200. This is an unrealized profit of $2,000, since you haven’t sold any of your shares yet. Selling the shares will realize the gains and create a taxable event for the current tax year. If you decide to hold the shares, no additional taxes are owed under standard tax law. However, you may be subject to AMT.
Under AMT, you may owe $500 on the unrealized gains from exercising your stock options. You’ll pay that during the current year, on top of your normal taxes owed. This amount is then carried forward for the future sale of those shares.
So then, you decide to sell the 100 shares the following year, which triggers a capital gain. This closes the loop on those shares and the AMT credit that you’ve carried forward is used to offset the taxes owed on the sale at that time.
How Do You Qualify for the AMT Credit?
To qualify for AMT credits, your alternative minimum tax bill should be for deferred items, rather than exclusions. Deferred AMT items are those that incur an AMT due to a timing issue of when income is taxed versus earned. Exclusions are items that are not deductible under AMT and are lost forever.
Deferred AMT items include:
- Exercise of stock options
- Passive activities
- Installment sales
- Large partnerships
Examples of AMT exclusions are:
- Standard deduction
- Depletion adjustments
- Tax-exempt interest
- Home equity mortgage interest
- Taxes paid
- Miscellaneous deductions
Although it can be frustrating to owe the AMT, it is possible to get some of that money back as an AMT credit in the future. The AMT credit is a mechanism that enables investors to reconcile the traditional tax system with the AMT calculations based on timing differences of when income is recognized. When those AMT credits are used, they offer a dollar-for-dollar reduction in taxes owed because they have been prepaid under the AMT calculation.
Tax Planning Tips
- Understanding how exercising stock options affect your taxes can be a challenge. You may find it helpful to work with a financial advisor who can help you mitigate these issues. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Paying taxes is a part of earning income and growing your investments. Our tax return calculator estimates your federal tax obligations based on your personal details, sources of income, deductions and exemptions. It forecasts your tax liability and offers the ability to see how adjustments to the inputs affect your taxes.
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