Tax cuts don't always mean more money in your pocket

Author: Dave Davies

Published: January 11, 2005

Every time we hear about a tax cut by the government, we welcome the chance to pay less to the IRS.

But, believe it or not, there may be a downside

to these reductions in our tax bill.

One potential pitfall is the alternative minimum tax, or AMT as it is more widely known. Because of tax cuts, such as the ones in 2001 and 2003, more taxpayers now face the possibility of having to pay the AMT.

What is the AMT? Washington enacted the AMT in 1969 to address the problem of extremely wealthy individuals using various credits, deductions and other tax breaks to reduce or eliminate their income tax liabilities. The AMT calculation is designed to ensure these individuals pay at least some tax.

While it seems appropriate we all pay our fair share of taxes, there are a couple of troublesome issues with the AMT. First, the calculations for figuring the AMT are complex, making it difficult to anticipate when you are setting yourself up to pay the tax. Second, the tax rates and exemptions for the regular income tax - figured on your Form 1040 - are indexed for inflation, but those for the AMT are not, causing more and more people to pay it.

In addition, an AMT exemption was designed to protect most average income taxpayers from the tax.

However, as salaries have risen through the years, this exemption is losing its effectiveness and, as a result, each year more middle-class Americans must pay the AMT. In fact, the Tax Policy Center - a joint venture of the Urban Institute and the Brookings Institution - predicts that by 2010, the AMT could catch 37 percent of taxpayers with adjusted gross incomes of $50,000 to $75,000 and about 73 percent of those with adjusted gross incomes between $75,000 and $100,000.

Because the rules are so complex, explaining the intricacies of the AMT is beyond the scope of this article and you should consult your tax adviser. However, there are several points you should understand.

First, the AMT calculation is separate from your regular income tax calculation. If you think your situation may trigger the AMT, you'll need to complete IRS form 6251 with the help of your tax adviser. Basically, when the tax you calculate on your Form 1040 is greater than what you calculate on your Form 6251, you pay the amount from your Form 1040 (your regular income tax). However, when the amount you calculate on Form 6251 is greater than what you arrive at on your Form 1040, you must pay the amount from the Form 1040 plus the AMT, which is the difference between the two calculations.

Here's where the problem created by tax cuts comes in. Ironically, because the cuts reduced the amounts individuals calculate on their Forms 1040, they've in-creased the possibility the amount a taxpayer calculates on his or her Form 1040 will be smaller than his or her AMT calculation, which means more taxpayers are likely to be subject to the AMT.

Your chances of paying the AMT increase if you have several children, interest deductions from second mortgages, interest from private activity bonds, large capital gains or high state and local taxes. Exercising incentive stock options may also contribute to the likelihood you'll owe AMT.

Predicting whether you'll ever face the AMT is difficult but you should be prepared to discuss the possibility with your tax adviser as you keep an eye out for future tax cuts.