Your Taxes

It Doesn't Pay to Be in the A.M.T. Zone

Newspaper article

By: David Cay Johnston

Date: February 12, 2006

Source: Johnston, David Cay. "Your Taxes: It Doesn't Pay to Be in the A.M.T. Zone." New York Times(February 12, 2006).

About the Author: David Cay Johnston writes for the New York Times on topics relating to taxes and commerce. He was awarded the Pulitzer Prize in 2001 for his investigative reporting.

INTRODUCTION

While the American Civil War is remembered both for its high human cost and its ultimate benefits, it also marked the creation of one of the most despised aspects of modern life: the federal income tax. In 1861, facing mounting war costs and a deficit which eventually reached $2 million per day, Congress enacted the first tax on regular income, charging citizens a rate of three percent on all earnings above $800. While income tax is today generally viewed as a necessary evil, the United States government did not tax ordinary income for the first eighty-five years of its existence, relying instead on excise taxes levied against sugar, alcohol, and other products. For the forty-four years prior to the Civil War, the government collected no internal taxes whatsoever, subsisting solely on tariffs and the sale of land. Soon after the Civil War, the first income tax was abolished.

In the years that followed, debates raged over the constitutionality of taxing individual income. The income tax system as it exists today came into being in 1913, when thirty-six states ratified the sixteenth amendment to the Constitution, granting Congress the formal right to tax individual incomes. Later that year, an income tax on the top one percent of earners was passed, with rates ranging from one percent to a top value of seven percent. The twentieth century has seen a progression of tax debates in Washington, with the result being a tax system with both higher rates and far more complications.

While income tax policy remains a hotly debated political topic, most Americans agree that the system should be designed so that wealthier citizens pay a higher percentage of their income, a system known as a progressive tax system. Progressive systems are based on the belief that both poor and rich individuals need a similar amount of income to pay for essentials such as food and clothing, so those with more income should have more available to pay higher rates.

In 1969, the Secretary of the Treasury testified before Congress that in tax year 1967, 155 Americans had earned $200,000 or more but had paid no income tax at all. $200,000 in 1967 was approximately equivalent to $1.2 million in 2007, and Americans were outraged to learn that some of the highest earners in the nation were paying no taxes. Congress's solution was the Alternative Minimum Tax, or AMT.

The AMT is a separate income tax structure which exists alongside the standard tax structure. Taxpayers calculate their taxes twice, once using each of the two systems, then pay the higher of the two results. Since the AMT does not include some of the deductions allowed by the standard system, it frequently results in higher tax bills. While the AMT dealt with the immediate problem in 1969, its authors failed to index it to inflation, meaning that the cutoff did not increase over time. By the year 2005, many Americans were earning more than $200,000, and three million of them found themselves paying the Alternative Minimum Tax, a number projected to balloon to eighteen million by 2006.

PRIMARY SOURCE

After President Bush and Congress cut tax rates on dividends and long-term capital gains to a top rate of 15 percent in 2003, many investors bought stocks that make big cash payouts, expecting to benefit from lower taxes.

For many people, it has not worked out that way. That is because your actual tax rate may not be the one that the politicians talked about or that the Internal Revenue Service prints on its tax forms.

The culprit is the alternative minimum tax, which runs parallel to the regular income tax system. The A.M.T. has its own rules, including fewer deductions and just two tax rates, 26 percent and 28 percent. If the alternative tax is higher than the one you would owe under the regular tax system, you pay the higher bill.

Taxpayers subject to the alternative system pay the 15 percent rate on dividends and long-term capital gains unless they fall into a netherworld known as the phase-out zone. In 2005, that zone included married couples with annual incomes of $150,000 to $382,000, and single filers making $112,500 to $273,000.

Taxpayers in the phase-out zone pay even higher rates on wage income than other people trapped by the A.M.T.—as much as 35 percent on each additional dollar of income. For people whose income exceeds the phase-out zone limits, the statutory rates apply and any additional wages are taxed at 28 percent and dividends and long-term gains are taxed at 15 percent.

But those unfortunate enough to dwell in the zone must pay an effective tax rate on dividends and long-term gains of 21.5 percent or 22 percent, instead of 15 percent.

This extra tax is just one of the many painful features of the alternative levy. Under the alternative tax, people cannot deduct property taxes, for example, so their cost of homeownership climbs. But the interaction of the alternative tax and the 2003 Bush tax cuts directly affect the taxation of investments in stocks.

Imposing higher taxes on people at such incomes was not part of the original intent of the alternative tax. Congress created it in 1969 to make sure that those making more than $200,000—the equivalent of more than $1 million in today's dollars—could not live tax free by making unlimited use of exotic tax breaks like the oil depletion allowance.

Over time, Congress has excluded most of these tax breaks from the alternative levy. And in 1986, Congress revised the list of tax deductions that would push a taxpayer into the alternative system to include those routinely taken by most Americans. They include the standard deduction; personal exemptions for the taxpayer, spouse and children; deductions for state income and local property taxes; and even some medical deductions for the severely ill or injured.

The White House has said repeatedly that it will take measures to mitigate the impact of the alternative tax on people of moderate income, and restore at least some of the benefits of the Bush tax cuts that were taken back by the alternative tax.

In his State of the Union address, President Bush again called for making his tax cuts permanent, but he said nothing about overhauling or repealing the alternative minimum tax.

The A.M.T. has become such a money maker that by 2008 its repeal would cost more than repealing the regular income tax, according to the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution, two research institutions in Washington.

Over the next decade, the alternative tax will cost Americans $1.1 trillion in additional taxes, of which $739 billion is a result of the Bush tax cuts not being integrated into the levy, according to a report by the Congressional Joint Committee on Taxation. Those hit hardest are couples with two or more children who own their homes, invest and make $75,000 to $500,000 a year, according to the Tax Policy Center computer model.

While the administration has never proposed a specific plan to change the alternative minimum tax or to exempt dividends and long-term gains from the phase-out range, Congress initiated a small adjustment five years ago. It exempted the first $58,000 earned by married couples ($40,250 for singles) from the alternative tax calculation for 2001 through last year. This patch was not renewed for 2006, dropping the exemption to $45,000 for couples ($33,750 for singles) unless a new patch is voted into law.

Investors who have fallen into the phase-out zone face a quandary. Should they buy high-dividend stocks, even though they will not get the full benefit of reduced tax rates? The short answer is this: if it makes sense to buy the shares for other reasons, the extra tax probably should not deter them.

Rich Carreiro is one of those rare taxpayers who knew before he invested that he would not get the 15 percent rate on dividends. Mr. Carreiro, 38, takes a keen interest in the tax code, which is as complex as the code he works with as a software engineer in Arlington, Mass.

"To move out of dividend-bearing stocks just because I am paying 22 percent instead of the promised 15 percent would cause more harm than good," he said. "The idea in investing is not to minimize your tax; it is to maximize your after-tax return. After all, you can pay no tax by living off money you've stuffed in your mattress, but that doesn't make good sense."

One investing change that Mr. Carreiro and his wife did make because of the alternative tax was to avoid money market and bond funds that buy private activity bonds—those whose proceeds are used by private entities. Under the alternative system, income from these bonds is subject to taxes at the higher rates applied to wages.

Ed Grogan, a financial planner in Gig Harbor, Wash., says he tells clients not to let the extra tax deter them from buying stocks that they believe have a good future just because they will not qualify for the 15 percent rate on dividends.

"Stick with your investing fundamentals," he said.

Stephen J. Entin, a proponent in Washington of the supply-side theory of taxation that favors eliminating most taxes on capital, said last year that denying the 15 percent tax rate to some investors "poisons the tax cut."

Mr. Entin, the president of the Institute for Research on the Economics of Taxation, said in an interview last month that "you should be a little more ticked off at the world" if you are in the phase-out range and, like Mr. Carreiro, pay higher tax rates on dividends.

In a report, Mr. Entin wrote that investors are still better off under the 2003 tax rate cuts even if they are in the phase-out range. That is because the phase-out rates are still significantly lower than the tax rates in effect before the 2003 tax cuts.

Investors who are stuck in the phase-out range and avoid dividend-paying stocks may find that they still have a vexing tax problem. That is because the higher tax rates that apply to taxes on dividends also apply to long-term capital gains. If you are in the zone, you must pay the higher tax on capital gains, and you cannot take a federal deduction for state and local income taxes on them.

Of course, if the stocks pay no dividend, no tax is due until they have been sold. By that time, your income could be above or below the phase-out range, so you could qualify for the 15 percent tax rate on their gains.

By then, though, Congress may have made the tax code even more complicated.

SIGNIFICANCE

In the years since the AMT was enacted, several adjustments have been made to the law. Typical of these was a change in 2005, a temporary adjustment of the floor for the tax, which allowed several thousand taxpayers to avoid falling into the AMT range. In 2005, the Congressional Budget office projected that by 2016 the AMT would impact thirty-three million taxpayers, generating more than $81 billion in revenues.

In mid–2006, with several million more taxpayers facing a potential AMT bill, the U.S. Congress passed a $70 billion tax reduction bill. Along with temporary extensions of several tax reductions, the bill also provided a temporary adjustment to the AMT, preventing approximately fifteen million Americans from falling under its provisions. While a permanent fix for the AMT is clearly needed, Congress may find such a change politically difficult to swallow. Future budget deficit projections are based on the assumption that the AMT will remain in place; without the AMT and the billions of dollars it is projected to generate, future budget deficits will soar even higher than before, putting pressure on lawmakers to cut spending. For this reason, it appears likely that the AMT may continue to be readjusted each year for the foreseeable future.

FURTHER RESOURCES

Books

Peckron, Harold S. Alternative Minimum Tax: What You Need to Know About the "Other" Tax. Naperville, Ill.: Sphinx Publishing, 2005.

Tyson, Eric, Margaret Monro, and David Silverman. What the IRS Doesn't Want You to Know: A CPA Reveals Tricks of the Trade. New York: John Wiley & Sons, 2003.

Periodicals

Gleckman, Howard and Paul Barrett. "How the AMT Wallops Capital Gains." Business Week 3984 (2006): 45.

Jeffrey, Terrence. "The Anti-Family Tax is Coming Your Way." Human Events 62 (2006): 5.

"The GOP's Tax Windfall." U.S. News & World Report. 140 (2006): 25.

Web sites

The Brookings Institution. "Key Points on the Alternative Minimum Tax." January 21, 2004. <http://www.brookings.edu/views/op-ed/gale/20040121amt.htm> (accessed June 2, 2006).

Congressional Budget Office. "The Alternative Minimum Tax." April 15, 2004. <http://www.cbo.gov/> (accessed June 2, 2006).

United States Department of the Treasury. "History of the U.S. Tax System." <http://www.ustreas.gov/education/fact-sheets/taxes/ustax.html> (accessed June 2, 2006).