By Geoffrey M. Zimmerman, CFP
Learn more about Geoffrey on NerdWallet’s Ask an Advisor
During your year-end tax planning, you might find that you’re going to be stuck paying the alternative minimum tax, an alternative method of calculating income tax that runs parallel to the regular tax system. If that’s the case, you should focus on reducing your income taxes in the years ahead.
Generally, you’d do that by increasing your level of ordinary income that is normally taxed at your highest federal marginal tax rate. This might seem like a counterintuitive way to reduce the sting of your tax liability, but it makes sense when you consider how the AMT works and the tax brackets associated with each tax system.How the AMT works
Under the regular system, in which taxable income largely determines your bracket, the highest tax rate is 39.6%. Under the AMT system, the highest rate is 28%. The AMT has fewer tax brackets, but is more complicated because certain types of income, exemptions and itemized deductions factor into your taxable income. You calculate both your regular federal taxable income (RTI) and your alternative minimum taxable income (AMTI) to determine your tax liability under each system, and then pay the higher of the two.
So if you have to pay AMT, increasing your ordinary income up to a certain threshold actually allows you to take advantage of the lower of the two highest rates. It does not involve paying less in taxes; instead, it is a strategy to accelerate income to take advantage of the 28% tax rate under the AMT system now rather than having that increased income be exposed later to a rate of 39.6% under the regular system.
Paying AMT is expensive, but you can minimize its impact on your income if you fall into the “sweet spot.” This is the range where AMT income is more than $494,900 —the point at which the AMT exemption phases out for married couples filing jointly —and below the point at which AMT and the ordinary tax rate converge.
Due to the way the phaseout of the AMT exemption works, your effective AMT marginal rate can be as high as 35%. But once the exemption is fully phased out, your AMT marginal rate drops down to 28% and remains there until your income gets high enough to push you back into the ordinary tax system where you pay 39.6%. We refer to this window, where the marginal tax rate is 28%, as the AMT sweet spot.
This sweet spot depends on your financial situation. If you’re in this range, and if you anticipate being in the top ordinary tax bracket in subsequent years, you can and should look for ways to increase your income and have it taxed at the highest AMT rate rather than the highest federal rate.Increasing income
Accelerating your income is a strategy to exploit the difference between the highest AMT marginal rate of 28%, and the highest ordinary rate of 39.6%. It involves choosing to increase income now to pay tax at 28% rather than at 39.6% in the future on the higher income.
Two of the more common methods of accelerating income are exercising nonqualified stock options and making a partial conversion of traditional IRA assets to a Roth IRA.Exercising nonqualified stock options
Nonqualified stock options differ from incentive stock options in that you generally pay ordinary income tax on the difference between the grant price and the price when you exercise the option, or the bargain element.
Corporate executives can strategically increase income by exercising and selling nonqualified stock options, particularly those which are deep in the money —meaning the current stock price is well above the exercise price of the option in your contract —or those that are close to expiration, or a combination of both.
For example, if you have 1,000 stock options with an exercise price of $5 that expire in the next 12 months and the stock is currently trading at $105, the exercise of those options will create $100,000 in income. Since the options expire in the next 12 months, you need to exercise them this year or next. If you are in the 28% AMT bracket this yearbut expect your income to be especially high next year —pushing you out of AMT range and into the top 39.6% ordinary income bracket — then you should consider exercising your options this year.Roth IRA conversion
Assets in a traditional IRA are tax-deferred, meaning that any gains from growth, interest or dividends in that account are not taxed when they occur. Withdrawals are taxed as ordinary income. In addition, mandatory withdrawals from traditional IRAs must begin no later than age 70½. By contrast, qualified distributions from a Roth IRA are tax-free, and Roth IRAs are generally not subject to required minimum distributions, or RMDs.
When you convert assets from a traditional IRA to a Roth IRA, that amount is considered taxed income in the year of conversion. If you have a large, ongoing income stream that you expect will persist into retirement —such as a pension, income from real estate holdings or retirement plan balances that will trigger large RMDs —and will be taxed at top rates, then you might want to do a partial conversion of traditional IRA assets to a Roth IRA during the years when you are in the top AMT rate of 28% rather than the top ordinary federal rate of 39.6%.
In the long run, this strategy can allow you to grow assets in the Roth IRA tax-free for yourself, your spouse and/or your next generation of beneficiaries. The converted amount isn’t subject to minimum distribution requirements. If you’re concerned about the possibility of a future increase in income tax rates, moving the assets to a Roth IRA will help you hedge the risk. And if you need to draw on assets in your retirement years, you can do so without creating additional tax liability.Talk to a tax pro
Note that with the election of Donald Trump, tax reform could be on the table in the future. If Trump’s proposed tax changes— which call for a reduction of the highest regular tax rate and the elimination of AMT —are adopted, AMT tax strategies could become obsolete. However, only Congress has the power to change tax laws, so it’s yet to be determined how likely these changes are. Talk to a tax professional to discuss the best tax strategies for your situation.
The article Paying More Tax Today May Be Your Best AMT Strategy originally appeared on NerdWallet.