The Middle Class Struggles with the Alternative Minimum Tax

February 12, 2006

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

By DAVID CAY JOHNSTON

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.


Copyright 2006The New York Times Company