AMT, the Tax We Love to Hate

About four million unlucky taxpayers will discover that they must pay the alternative minimum tax when they file their 2011 tax returns next year. For most, it can be a nasty surprise, wiping out crucial deductions and exemptions they normally claim, resulting in a bigger tax bill.

But if you knew in advance that you might be subject to the AMT, you could make some smart year-end tax-planning decisions to mitigate the damage. We’ve created a simple calculator to help you figure out if you might be an AMT victim.

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The AMT is a parallel tax system created more than 40 years ago to prevent excessive use of tax breaks by the very wealthy, ensuring they paid at least some tax. But because it was never indexed for inflation, the AMT has morphed from a “class tax” into a “mass tax”, affecting millions of middle-class Americans each year. The number of taxpayers owing the AMT grew from about 20,000 in 1970 to about four million in 2011, according to the nonpartisan Tax Policy Center.

The AMT does not allow deductions for state and local taxes, home-equity loan interest (unless the borrowed money was used for home improvements), or tax and investment expenses -- write-offs that save money in the regular tax world. Nor does it allow personal exemptions -- worth $3,700 this year -- for yourself, your spouse and each of your dependent children. Consequently, taxpayers with large families or those who live in high-tax states, such as California and New York, are more likely to find themselves subject to the stealth tax.

Normally, if you pay quarterly estimated state income taxes or have a real estate tax bill due in January, you can prepay it in December and boost your deductions on your 2011 federal tax return due next spring. But if you're subject to the AMT, this sooner-rather-than-later strategy won't work for you.

Beyond denying such write-offs for taxes, the AMT also puts the squeeze on deductions for medical expenses. In the regular tax world, medical costs in excess of 7.5% of adjusted gross income can be deducted. In AMT-land, the threshold is 10% of AGI. (The AMT does, however, permit tax deductions for charitable contributions, so you can go ahead and make your usual year-end donations.)

The top AMT rate is 28%, well below the 35% at which the regular tax maxes out. But because more income can be taxed by the AMT, you could wind up with a bigger tax bill. In fact, you only owe the AMT when it costs you more than the regular tax.

Although the AMT exemption is not indexed for inflation, in recent years Congress has protected millions of taxpayers by passing temporary patches to raise the level, usually one year at a time. Taxpayers whose income exceeds the AMT exemption must calculate both regular tax and AMT liability and pay the larger amount. For 2011, the AMT exemption is $48,450 for individuals and $74,450 for married couples filing jointly.

But unless Congress acts, exemption levels will drop to $22,500 for individuals and $45,000 for married couples filing jointly in 2012, exposing 31 million taxpayers to the AMT next year, according to Tax Policy Center estimates.

That means virtually 100% of married couples with incomes between $50,000 and $475,000 -- even those who claim the standard deduction -- would be subject to the AMT next year unless exemption levels are raised, says Michael Kitces. Kitces is the director of research for the Pinnacle Advisory Group, in Columbia, Md., and developed the data that serves as the basis of our AMT calculator. Single taxpayers are threatened, too. Without another patch, almost all single taxpayers with income between $150,000 to $300,000 will be subject to the AMT in 2012.

So check out our calculator before you decide to pay state income or real estate taxes in December that you could put off until January. If it looks like you’ll be an AMT victim, don’t bother.

Sneak preview: new tax benefits -- as well as burdens -- for 2012