Any successful investment adviser understands that it's not about the return you earn; it's about the return you keep. Advisers need to manage a portfolio by keeping one eye on the market and the other eye on the tax man, with the goal of earning the maximum after-tax return possible, given a client's risk tolerance. As a result, successful advisers have learned the basic — and even some of the advanced — rules of the tax code. But one that continually frustrates advisers is the alternative minimum tax.
EXTREME CASES
The AMT was originally created in 1970 after the Treasury an-nounced that 155 high-income individuals had managed to pay no income tax. The Tax Policy Center estimates that 4.5 million taxpayers will owe AMT in 2015, a projection that dropped significantly after the 2012 tax reform act introduced inflation adjustments to slow the growth of the tax. Taxpayers and their CPAs spend countless hours planning around this tax, and advisers should be part of those discussions as well.
The best way to describe the AMT is to think of it as an entirely separate set of rules with its own dictates on what's taxable, what's deductible and how the tax is calculated. After you figure your tax liability under this “alternative” system, you compare it to the tax calculated under the “regular” system, and then you pay the greater of the two. On top of that, you still have to pay any other taxes, such as self-employment tax or the Medicare tax on investment income.
The AMT tax rate is 26% on AMT taxable income up to $185,400 (for 2015), and 28% over that, with either a 15% or 20% rate on long-term capital gains. Those rates are generally lower than the ordinary tax rate for people at those same income levels. However, the tax under AMT can be larger because the rates are applied to a larger base of income, thanks to the AMT adjustments.
Knowing those adjustments can help advisers and their clients manage the effect of AMT. For example, while interest from municipal bonds is generally tax-exempt, that's not true for AMT. Bonds classified as private-activity bonds pay interest that is taxable for AMT. These bonds tend to pay a higher interest rate than other municipals, but knowing a client's tax situation can help you determine if these bonds are right for them. No adviser wants to recommend to a client bonds that are tax-exempt, only to later have an uncomfortable conversation about why those bonds led to a larger AMT liability.
MISCELLANEOUS DEDUCTIONS
Similarly, investment advisory fees fall into a category of expenses called miscellaneous itemized deductions. While these expenses are deductible for regular tax if they exceed 2% of adjusted gross income, they aren't deductible under AMT under any circumstances. It's good to know your client's tax situation before touting the tax deductibility of your fees.
AMT isn't necessarily always a bad thing. Because the top AMT rate is just 28%, taxpayers sometimes find their marginal tax rate under AMT is less than that under the regular tax, which can be as high as 39.6%. That can create opportunities for IRA withdrawals or short-term capital gains at rates lower than those who escape AMT. The nuances of the AMT calculation are such that it's always best to do a “with” and “without” calculation before deciding to recognize that extra income.
In some cases, additional tax paid due to AMT can be used as a tax credit in future years. Advisers can help clients accelerate the recovery of those credits, rather than giving those tax dollars to the government.
It's very difficult to make generalizations about what income levels are subject to AMT, as there are so many variables at play. For example, because state income and property taxes aren't deductible for AMT, those in higher tax states are more likely to pay AMT, as are those who claim more dependents. Good financial advisers will work with their client's tax adviser and do their part to avoid, or at least manage, the impact of this tax.
Tim Steffen is director of financial planning for Robert W. Baird & Co. Follow him on Twitter @TimSteffenCPA.
