with Michael Kitces, CFP®, ChFC, REBC, RHU
The Financial Planning Association hosted a session in its Virtual Learning Center in January on "The Financial Planning Implications of Alternative Minimum Tax (AMT)," presented by Michael Kitces, CFP®, ChFC, REBC, RHU. What follows are some questions that participants posted online after the session, with Kitces' responses.
Pre-tax Retirement Plan Contributions
Q. In high income-tax-rate states, taking advantage of pre-tax retirement plan contributions could reduce state taxes to the point that AMT falls away—yes?
A. Yes, that is correct. Any non-AMT-adjustment (or preference) deductions, such as contributions to a 401(k), 403(b), or other tax-qualified retirement plan, will reduce taxable income, thereby reducing state income taxes due and the adjustment that they create (not to mention otherwise reducing income and its regular/AMT tax liability).
Q. What items (besides ISOs) have you found create the largest delta between regular tax liability and AMT liability?
A. ISOs are certainly the largest common potential impact for AMT. Other items that might create a large delta include substantial depreciation and/or gain/loss adjustments on business property, substantial "one-time" miscellaneous itemized deduction losses such as a large variable annuity loss.
W-2 income of $800k+
Q. Single client has W-2 income of $650K+. He also exercised ISOs (add'l $200K AMT add back, if AMT would apply) and NQSOs in 2004. We paid withholding tax already on the NQSO spread. CPA said AMT no issue b/c of the high income. Agree? Also, client had opportunity to take an $80K bonus in 2004 or 2005. CPA said defer. Agree? Is this always going to be the case where once you're at X W-2 income, AMT isn't an issue, b/c of deductions phaseout?
A. I would expect that a $200K AMT adjustment would still subject a $650K taxpayer to some level of AMT (I'd estimate that you only need about $100K of AMT adjustments to cross into AMT at that income level). However, NQSOs tend to withhold at the high end of the tax scale (35%), while the top AMT tax rate is 28%—consequently, although you might find some AMT liability, it doesn't necessarily mean you're under-withheld, depending on what was withheld from employment wages as well.
The decision about whether to defer the bonus or not would depend on whether the client is expected to be subject to AMT in 2005, and what the client's overall income is expected to be in 2005. Offhand, it sounds like it was probably the right decision, as apparently most of this year's high-income items were one-time events and that next year's taxable income will be substantially lower.
Gambling Losses and the AMT
Q. Are gambling losses deductible under AMT?
A. For nonprofessional gamblers, gambling losses are deductible to the extent of gambling gains, and are taken as miscellaneous itemized deductions. Consequently, the losses are subject to the AMT adjustment (to the extent they were allowable in the first place) like other miscellaneous itemized deductions.
However, professional gamblers can deduct their gambling losses as a business deduction (although still only to the extent of their gambling gains), and would avoid AMT adjustment.
Q. That could be very expensive indeed for a nonprofessional gambler. For example, gambling winnings of $500K, gambling losses of $499K. Can you point me to a reference that defines the criteria for gaining professional gambler status?
A. I'm not aware of any particular resources offhand that serve to define "professional" gambler, but generally speaking we're talking about someone that wants to deduct their gambling losses as a business expense on their Schedule C. Thus, we're really just talking about whether the taxpayer's gambling constitutes a business or a hobby, under the same set of rules that would be applied for any other profession-versus-hobby differentiation.
There may be some IRS material that has further defined this delineation, but it's not an area I'm extremely familiar with. I believe that Publication 529, on various itemized deductions, has some additional discussion on gambling losses—I'd suggest you start there in your further exploration of the issue.
Investment Management Fees to Basis
Q. Is there any sustainable position that allows one to assign a portion of investment management fees to basis (as opposed to being a current year deduction)?
A. There's nothing that I'm aware of that allows you to otherwise assign investment management fees to basis, and thereby not deduct them. Ostensibly, one could simply 'forget' to deduct them in the first place.
However, bear in mind that this only produces an adjustment to the extent that the deduction was there in the first place. At worst, the end result of the AMT adjustment is to disallow a deduction that you took, leaving you as though you never had it in the first place. Thus, you don't ever gain anything by avoiding deductions that are AMT adjustments. At worst, you simply take the deduction for regular tax purposes, and then give it back again, and end out in the same position as never deducting it in the first place. And sometimes, you end out better.
Consequently, I'd generally always recommend taking any and all deductions that are appropriate, and let the AMT cards fall where they may.
Evaluation of Tax Rates
Q. For comparisons of tax rates, is it not more appropriate to compare average tax rate vs. the AMT rate rather than marginal tax rate vs. AMT rate? Either way, how do you calculate average or effective tax rate—using AGI or taxable income as the denominator?
A. Generally, evaluation of tax rates for the purposes of making tax-based decisions occurs at the marginal level—what is the impact on my next $1 of income and/or $1 of deductions, to which your AMT marginal rate applies.
For example, when calculating whether your next dollar of income will be subject to a 28% AMT rate or a 35% regular tax rate, the fact that you have paid $XXX in tax already, producing some average/effective tax rate, really has no bearing on what the tax rate will be on this next dollar of income. That's a measure for the marginal tax rate, and why in the context of planning with AMT issues we were generally looking at marginal tax rates.
Flat Tax in Disguise
Q. Do you think that there will be a migration toward an AMT-only system, and this is why AMT reform has not been addressed?
A. The White House has certainly been clear that a flat tax is one type of tax reform they are interested in seeing, and it's certainly true that AMT operates very closely to a flat-tax-with-low-income-exemption regime.
I'm not aware of any authority that indicates that there is a deliberate plan to use AMT as a de facto flat tax, but it's certainly a possibility—mere inaction by Congress will move us increasingly toward this flat-tax-like regime in the coming years (not to mention what Congress might do to accelerate the shift more).
I certainly do not expect to see substantial AMT reform driven by the White House as long as they are expressing interest in a flat tax system. At best, we may see modest adjustments to the AMT exemption amount, while other regular and/or AMT deductions are taken away.