Alternative Minimum Tax: Understanding and Navigating Its Impact

The Alternative Minimum Tax (AMT) is a parallel tax system designed to ensure that individuals who benefit from certain deductions, exemptions, and credits still pay a minimum amount of tax. Initially, the AMT was introduced to prevent high-income taxpayers from using legal tax benefits to pay little or no income tax. However, over the years, it has come to affect a broader segment of taxpayers. It runs as a parallel tax system with its own rates, its own exemption, and its own preference items, and you owe the higher of the two computations.

The AMT operates alongside the regular tax system but with different rules for deductions and income inclusion. It eliminates or reduces certain deductions and credits, potentially resulting in a higher taxable income under the AMT than under the regular tax system. Taxpayers must calculate their tax liability under both systems and pay the higher amount.

Key differences include:

• The AMT disallows personal exemptions and the standard deduction.
• State and local tax deductions are not permitted under the AMT.
• Certain “preference items” are added back into your income for AMT purposes, such as a portion of the interest on second mortgages not used for home improvement.

The impact of the AMT can be significant, leading to an unexpected tax liability at the end of the year. It primarily affects middle to high-income taxpayers, especially those with large families, those who live in states with high state and local taxes (SALT), or those who have significant deductions under the regular tax system. The AMT rate is either 26% or 28%, depending on the amount of AMT income.

The TCJA in 2017 raised the income thresholds at which the AMT exemption begins to phase out — from $120,700 for single filers and $160,900 for joint filers to $500,000 for single filers and $1 million for joint filers—with annual inflation adjustments. Absent further legislation, both the larger exemption and the higher phaseout thresholds were scheduled to expire after 2025, which would have increased the number of filers subject to the AMT in 2026.

The one big beautiful bill act (public law 119-21) (OBBBA) preserves the higher exemption amount and phaseout thresholds while making a modest change to the inflation indexing for the phaseout thresholds. Beginning in 2026, the phaseout thresholds are reset to their 2018 TCJA levels — $500,000 for single filers and $1 million for joint filers—and then indexed for inflation going forward.

The AMT exemption phaseout rate also increases from 25 percent under prior law to 50 percent starting in 2026, meaning the exemption is reduced twice as quickly once income exceeds the applicable threshold. That doubling matters more than it sounds: inside the phaseout range each extra dollar of AMTI now strips fifty cents of exemption, so a taxpayer in the range faces an effective AMT rate of $28\%\times 1.5=42\%$ on income in that band.

Table 6.2 is the table you need to size an ISO exercise. The exemption shelters AMTI up to the exemption amount; above the threshold it erodes at 50 cents on the dollar until it is gone; and the AMT rate itself steps from 26% to 28% once AMTI net of the exemption crosses $244,500.

The planning number is the gap between your projected AMTI and the point where tentative AMT overtakes regular tax — the “AMT pad,” the amount of ISO spread you can absorb in a year before writing a check. Compute it in October on Form 6251, exercise into it, and stop. Exercising past the pad is not forbidden; it is simply a decision to prepay tax on stock you cannot yet sell, which is the phantom-income problem described in section “When You Cannot Pay”.

While it’s not always possible to completely avoid the AMT, there are strategies to minimize its impact:

Understand Your Exposure

Use tax planning software or consult with a tax professional to determine if you are likely to be subject to the AMT. Early identification can help you plan accordingly.

Manage AMT Triggers

Certain income and deductions are known triggers for the AMT. For example, exercising Incentive Stock Options (ISO) can significantly increase AMT liability. If possible, manage the timing of these events or spread them out to avoid AMT implications.

Maximize Retirement Contributions

Contributions to traditional 401(k)s and IRAs can reduce your taxable income and potentially keep you out of AMT territory.

Invest in AMT-Free Municipal Bonds

Interest income from most municipal bonds is exempt from federal taxes and the AMT. Shifting investments to these bonds can reduce AMT exposure.

Timing of Deductions

If you’re close to the AMT threshold, consider the timing of certain deductions. For instance, delaying the payment of property taxes or state income taxes could prevent you from triggering the AMT in a given year.

Utilize AMT Credits

If you pay the AMT in one year due to deferral items (like ISO exercises), you may be eligible for a credit in future years. This credit can offset your regular tax but not below your AMT liability.

The AMT credit, in practice. The AMT you pay in a year of ISO exercise is not lost — it generates a credit you can use in any future year when your regular tax exceeds your tentative AMT. The credit is non-refundable and capped each year at the spread between regular tax and tentative AMT, so a large ISO-driven AMT bill may take several years of normal returns to recoup fully. The mechanics are unforgiving: you have to claim the credit yourself, every year, until it is exhausted.

1.

Pull every prior return where you exercised ISOs or otherwise paid AMT; Form 6251 on those returns tells you the AMT actually paid.

2.

For each year you previously claimed any portion of the credit, subtract the amount used — the remainder is the unused credit you carry forward to the current year.

3.

File Form 8801 (Credit for Prior Year Minimum Tax) with this year’s return to compute the current-year credit, apply it against regular tax, and establish the new carryforward.

4.

Track the running carryforward in your tax file across CPAs and across years. The most common failure mode is paying a large AMT bill in the year of an ISO exercise, then changing preparers two years later and never seeing the credit on subsequent returns. The credit is yours; nothing in the system reminds you it exists.

The second parallel system: your state’s AMT. Everything above is federal. Four states run their own AMT on individuals — California at 7%, Minnesota at 6.75%, Colorado at 3.47% of state AMTI net of normal state tax, and Connecticut on a formula taking the lesser of 19% of adjusted federal tentative minimum tax or 5.5% of adjusted federal AMTI. Iowa, Maine, and Wisconsin repealed theirs. Colorado and Connecticut both start from the federal computation, so you generally owe them nothing unless you owed federal AMT first — which keeps their reach narrow. Minnesota and California supply their own, and California’s is the one that matters, because it is calibrated to a version of the Code that no longer exists.

California froze its AMT conformity deliberately, and the way it did so is easy to misread. SB 711 (Stats. 2025, ch. 231) is known as the bill that advanced California’s general conformity date to January 1, 2025. The same bill added R&TC §17062.1, which carves the AMT back out and applies the federal provisions as they read on January 1, 2015 — before TCJA raised the exemption, and before OBBBA made that increase permanent. Cite SB 711’s headline date for AMT purposes and you will be a decade wrong. California therefore never received the relief that pulled most households out of the federal AMT, and it supplies its own exemption and phaseout under R&TC §17062(b) instead, indexed to the California CPI. For 2025, the last year with published figures, the exemption is $123,667 married filing jointly and $92,749 single — and, unusually, head of household uses the single amount rather than getting its own. The phaseout begins at $463,745 joint and $347,808 single, and the exemption is gone entirely at $958,413 and $718,804.

Set those against the federal thresholds in Table 6.2 and the problem is obvious. California’s phaseout starts at roughly a third of where the federal one does. A married couple in the Bay Area can sit several hundred thousand dollars clear of federal AMT and be squarely inside California’s, which is precisely the position a two-income household holding ISOs tends to occupy. And the ISO spread is a California preference item on the same terms as the federal one — Schedule P (540), line 10 — so the exercise that generated no federal AMT can still generate a state bill.

This leaves you with two critical planning rules. First, your “AMT pad” is actually two separate numbers, and for a California resident, the state threshold is almost always the binding constraint. Always model both calculations before sizing an ISO exercise; relying solely on federal projections will create an illusion of safety where none exists. Second, California maintains its own credit system on FTB Form 3510 (the state counterpart to Form 8801). Prior-year state AMT paid on deferral items — including the ISO spread — carries forward with no stated expiration, because the credit is computed cumulatively across all prior years under the IRC §53 formula that R&TC §17063 adopts. The Schedule P instructions also place it outside California’s $5 million business-credit limitation. Just like the federal credit, state AMT credits require diligent tracking; nothing in the system will remind a new preparer that the carryforward exists.

Keep the calendar in mind: while the federal thresholds in Table 6.2 reflect 2026, the California figures above reflect the 2025 tax year (the Franchise Tax Board publishes its inflation-adjusted thresholds late alongside annual tax forms). Always verify the latest numbers on Schedule P before finalizing an exercise. The structural point survives the indexing: California’s AMT thresholds sit far below the federal ones, and the state has just re-affirmed the 2015 conformity date rather than closing the gap. Nothing stops a future legislature from conforming. Until one does, plan against the law as it stands.

Consider a taxpayer in a high-tax state with significant state income and property taxes. Under the regular tax system, these are deductible, but for AMT purposes, they are not. If this taxpayer also exercises a large number of ISOs, their AMT taxable income could significantly exceed their regular taxable income, leading to AMT liability. By spreading out the exercise of ISOs, investing in AMT-free municipal bonds, and maximizing retirement contributions, the taxpayer could potentially reduce or avoid the AMT.