The purpose of the AMT is to make sure that really rich people can’t just give all their money to charity instead of paying taxes. So if your income is high enough, you have to calculate your taxes twice — once the normal way, and once a second time to make sure you are paying “minimum” taxes for your income level.
Basic AMT Explanation and Information
Then you have to pay the higher amount. This is very burdensome if you have to do it by hand, but if you use a computer program, it’s a relatively simple step. If your income is less than the low six-figures, it will probably not apply to you. The people most commonly affected are those with lots of exclusions and deductions (e.g. many children, church donations, mortgage, etc. etc.) and a relatively high income.
Why was AMT Created?
The AMT was created because during the early 1960s a small number of households with really high incomes paid virtually no income tax. There are ways to generate income without paying tax. The easiest way is to purchase “tax free municipal bonds”. These are bonds issued by cities and the interest is not taxed.
Other ways include offsetting capital gains with capital losses, maximizing deductions, including donating to charities, etc.
The AMT is a parallel, essentially “flat” tax system. It uses a different set of calculations for deductions and tax exemptions. It was designed to catch those households that had gamed the system so that they paid no tax, and tax them. The problem is that it was not indexed for inflation.
How does AMT tax Change Each Year?
As inflation increased the earnings of households, the point where a taxpayer becomes obligated to pay it became relatively lower and lower. Today, hundreds of thousands of people pay this tax, usually because they had a one-time special windfall related to the purchase or public offering of a company that they held stock in (or stock options like a lot of employees at high tech companies). For people who live in really high cost of living places like San Francisco or New York City, the gap between their incomes and the AMT threshold has become quite narrow.
The problem with “fixing” this tax so that it would be indexed for inflation is that the way Congress scores tax and spending bills assumes that all current legislation remains in place. There are estimates of how household incomes will continue to rise, and therefore the Congressional budget scoring assumes that those incomes start paying AMT at some point. Indexing the AMT for inflation would stop that from happening, and suddenly BOOM a lot of tax revenue that the model predicts will be received isn’t.
Future of AMT Tax
Of course, everyone knows that Congress isn’t going to let this happen anyway. There is a zero point zero zero percentage chance that Congress is going to allow millions of middle-class taxpayers to suddenly get trapped by the AMT. If you thought the Tea Party outrage over bank bailouts had an effect on Congressional elections, wait until you see how a few percentage points of income tax increases goes over with middle America. So every couple of years Congress passes a stopgap law that “patches” the AMT – but only a little bit and only for a short while. That way they can game their own budget scoring system while they kick the can down the road a few more years.
Like other similar problems like the “Doc Fix” for Medicare, eventually Congress will have to reconcile these insanities. When that happens, there will be a sudden expansion of projected future deficits, a lot of finger pointing, calls to tax rich people, and claims that it’s all a surprise (and that we knew all along).