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. Understanding the AMT, its impact on your taxes, and strategies to avoid it is crucial for effective wealth management.

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.

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.

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.