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Nobody enjoys paying taxes, but if you had to pick one tax that is almost universally disliked it’s the alternative minimum tax (AMT). As with any controversial topic, there are many opinions out there about AMT, and unfortunately there’s also a lot of misinformation.

What is the AMT?

The easiest way to envision the AMT is to think of it as a tax floor. Once your tax rate drops to that floor, AMT won’t allow it to go any lower.

Originally, AMT was intended to crack down on wealthy people who weren’t paying any income taxes. Gradually, as inflation caused incomes to rise, the middle class started to get hit with this tax. The Tax Policy Center has estimated that 4.8 million taxpayers will owe a combined $35 billion in AMT for the 2017 tax year. That’s expected to grow to 5.6 million people shelling out $56 billion by 2026.

What are the chances AMT will affect you?

Unfortunately, there isn’t a simple way to know for sure if AMT will affect you. However, if your household income is over $200,000 per year, there’s 56% chance that AMT will show up on your tax return, based on information provided by the IRS.¹ With those odds, it’s probably a good idea to learn more about what triggers AMT, and see if there are ways to limit your exposure.

The news is a bit better for households with income between $100,000 and $200,000 a year, which face a roughly 4% chance of being affected, and households with less than $100,000 in annual income, which have a less-than-0.2% chance of being affected. That said, AMT could still kick in if the triggers listed below apply to you.

What triggers AMT?

These are some of the most common situations:  

Having a large number of dependents 
If you have a large number of dependents, you’re more likely to be affected by AMT than a household claiming just the personal exemptions.  If AMT kicks in, you’ll end up losing the deductions for your dependents and your personal exemptions, which could amount to thousands of dollars.²  
Living in a state or city with high taxes 
Under AMT you are not allowed a deduction for state or local income taxes or property taxes. So if you’re in an area with high taxes, you could be more exposed to AMT than someone in a state with lower tax rates.
Using a home equity loan for certain purchases 
Normally, you can deduct interest expenses on home equity loans (up to $100,000). However, AMT only allows this deduction if you used the loan proceeds to finance the purchase of a home or to make improvements to your primary or secondary residence. If you use a home equity loan to pay off credit card debt, pay for college or buy a car, you cannot deduct the interest expenses.
Exercising stock options 
Exercising qualified employee stock options (also called incentive stock options or ISOs) to buy stock at a discounted price is normally not a taxable event until you sell the shares for a profit. AMT creates a paper profit that’s taxable even though it’s not a real profit until you sell the shares.
Realizing a large capital gain 
Long-term gains (e.g., when you sell a home or other investments for a profit) are taxed at the same rate under both systems, but capital gains could put you over the AMT exemption threshold. That could cause AMT to kick in, which means you won’t be able to deduct state income taxes paid on the capital gains.

If you’re close to the AMT threshold, you can use the worksheet for line 45 on the Form 1040 to see if you’re at risk. You could also run your own projections using tax preparation software or hire a tax professional to do it for you.

Depending on your income and deductions, you may find yourself affected by AMT one year but not the next. If you’re close to the AMT threshold, it’s a good practice to do a multi-year projection to see which tax years may be the most at risk. For example, you could accelerate or delay certain transactions to minimize the risk of AMT, such as determining the best tax year to sell an asset (with a large gain) or the best time to pay state or local taxes.

However, don’t let the fear of AMT stop you from making sound financial decisions. For example, sometimes it can make sense to use a home equity loan to pay off some high-interest-rate debts, like credit card debt. Interest on credit card debt is not deductible on your tax return.  Even if AMT does not allow you to deduct interest on a home equity loan used to pay off credit card debt, the net benefit could still be worth it.

Getting hit with the AMT is unfortunate, but it’s not a reason to change your life goals or move your family to another state. AMT is just something to be aware of during your financial planning processes—it shouldn’t keep you up at night.

¹Source: Schwab Center for Financial Research, based on information in the IRS publication “Statistics of Income–2014 Individual Income Tax Returns Complete Report” (Publication 1304), Table 1.4.

²The personal exemption for tax year 2017 is $4,050. It begins to phase out with adjusted gross incomes of $261,500 ($313,800 for married couples filing jointly) and phases out completely at $384,000 ($436,300 for married couples filing jointly.)

How does it work?