In September, we discussed the looming U.S. tax increases (what we dubbed “taxaggedon”) scheduled by law to take effect on Jan. 1, 2013. Absent new legislation over the next couple of months, your taxes WILL increase at the beginning of 2013. It’s going to be a tax avalanche!
As I stated in the article, “If you earn income in the U.S., or otherwise have ties to U.S. income… you’re in the cross hairs. If nothing else, the tax collector cometh, and he knoweth your name. If you’re a taxpayer, you’re not going to like it.”
Many of my readers wrote in, asking for more details. Thus, I’ll expand on the point, with this standard disclaimer: Everything I’m about to describe is general guidance. For specific, personal tax questions, you MUST consult your own attorney or accountant.
However, if this article motivates you to do some perfectly legal and proper tax planning, then so much the better. You’ve got less than three months before the tax asteroid hits.
Alternative Minimum Tax
Many readers requested details about what the impending 2013 tax increases will mean if you’re subject to the Alternative Minimum Tax (AMT). The short answer is that it’ll be brutal. But first, let’s back up. What is the AMT?
Well, you may be surprised to learn that the U.S. has two tax codes. The AMT is a stand-alone system, paralleling the one with which most wage-earning Americans are familiar. That is, the usual way to pay tax is for a wage earner to receive a form W-2 and/or 1099 at the end of the year and then calculate total income on a Form 1040. Then you apply deductions to which you’re entitled. You pay tax based on the adjustments.
But in 1969, Congress created a different tax system — the AMT. Back then, a small number of wealthy people used all manner of deductions, shelters and loopholes to avoid paying any income tax at all. Eventually, it hit the media.
For example, in the late 1960s, some “millionaires” paid zero tax, which seemed unfair compared with most other working-stiff wage earners. Plus, zero tax deprived the U.S. Treasury of revenues to pay the costs of government — including the Vietnam War — and we can’t have that, right? So since 1969, every taxpayer is responsible for paying the higher amount of “regular” income tax, or AMT.
Here’s how it works. You (or, more likely, your accountant) calculate your tax, using the IRS Form 1040. Then you calculate your AMT obligation under a less well-known form, IRS 6251. If the AMT number is larger, then the difference applies to your overall tax calculation. In other words, it’s a new spin on that old Uncle Sam poster, “I Want You!”
When you prepare your taxes, you can take all the deductions you want. The deductions might be perfectly legal and proper. But then along comes AMT with a different set of calculations than the regular tax. You’re busted.
The bottom line is that AMT doesn’t allow the standard deduction, personal exemptions or many itemized deductions — like those for state taxes, children, medical expenses, etc. Also some income that’s not otherwise subject to regular tax gets added back for AMT purposes.
An Unkind, Wartime Tax — Still With Us
The AMT isn’t meant to be kind to taxpayers. It was a Vietnam-era wartime tax. The goal was to raise revenue for the government. The cynic might say that AMT treats high-income taxpayers as a class to be taxed hard — if not punished — for raking in the dough. Still, when all is said and done, AMT is, in most cases, much higher than the normal tax under regular rules. That’s the intent. Pay up.
At first, AMT touched a very small number of taxpayers. In fact, in 1970, only about 20,000 people were subject to AMT, out of a U.S. population of just over 200 million. Few people even knew that AMT existed. Few cared. AMT is only for “rich people,” right?
But last year, in 2011, over 4 million taxpayers were subject to AMT, out of a U.S. population over 311 million. That’s a significant number of taxpayers, and represents an explosive growth rate of over 200 times, during a period when overall national population rose by 55%. So now, AMT is much better known.
What’s in store for next year? According to the Tax Policy Center of the Brookings Institution, more than 31 million Americans will be subject to AMT in 2013. That is, the tax base for AMT will skyrocket from 4 million to 31 million in just one year — not quite an eightfold increase! There are two main reasons that AMT will reach out and touch more and more taxpayers. First, unlike the case with the regular income tax, AMT is not indexed for inflation.
Thus, in general, as wages and other income sources increase with inflation over the years, AMT reaches relatively deeper down into the taxpayer base. In that sense, AMT is a tax on inflation — rather fitting, since it was created during the Vietnam War, the granddaddy of modern inflation. Second, the famous “Bush tax cuts” of 2001–06 reduced tax liability for regular income (the 1040 kind), without any permanent adjustment to the parallel AMT rates.
Whoa! Wait! What does that last item mean? Well, as I discussed above, AMT originally targeted high-income taxpayers. So over the years, as inflation pushed more and more people into higher brackets, Congress passed temporary “patches” to the rates to keep AMT from impacting millions of otherwise middle-income individuals each year.
Guess what? The tax patches all expire on Dec. 31, 2012. Actually, it’s more like ripping the bandage off a bloody wound. So all of the otherwise deferred inflation built into the AMT rates over many years will come roaring back with a tax collector’s vengeance with the new year. Your withholding will instantly have to go up if you want to stay legal.
As of Jan. 1, 2013, AMT is moving way down the income levels — down the food chain, so to speak. Last year, in 2011, about half of taxpayers with incomes between $200,000–500,000 paid AMT. Under 4% of taxpayers with incomes between $100,000–200,000 took the hit. And less than 1% of those with incomes below $100,000 paid AMT.
As of 2013 — absent a major overhaul by Congress — about 94% of those with incomes between $200,000–500,000 will pay the tax, way up from 50%. About 80% of those with income between $100,000–200,000 will also feel the wrath of AMT. For households earning under $100,000? It’s hard to say, but it’s a safe bet that AMT will whack more than last year’s 1%.
If you live in a state with a high state income tax? Then the AMT will hit you harder than if you were in a low-tax state, due to the inability fully to deduct your state taxes.
If you have children? AMT will reduce that deduction as well. Indeed, the more children you have, the worse the hit, percentagewise.
If you have significant medical deductions? It doesn’t matter under AMT. You get to pay more tax. And so it goes.
What’s the answer? Congress should just meet and pass another AMT patch, right? Well, not so fast. First, Congress has adjourned for the year and won’t come back into session until after the elections on Nov. 6. By then, who knows what the political agenda will include? Tax reform by a lame-duck Congress in a hurry-up mode? Right away, I cringe at the thought.
Also, consider that extending the AMT for another year is a revenue item that could, in the first year, “cost” the government north of $100 billion — although in truth, nobody really knows how the accounting will play out. Right away, a new AMT patch is a huge hit to anticipated federal revenues, with all the political screaming and gnashing of teeth that comes with things like that.
Or suppose that AMT just went away? According to the Congressional Budget Office, repealing AMT would reduce federal revenues by over $2.7 trillion between 2012 and 2022. Again, it’s a massive hit to anticipated federal revenues. Overall, it would have severe consequences for perceptions of national solvency, the value of the dollar, interest rates on bonds and much more.
Clearly, the U.S. — and its taxpayers — are in a heap of trouble. There’s a tax avalanche coming. The most economically productive citizens are about to get slammed by a tax that was, originally, about “fairness” during the Vietnam War. Yet Congress is in a complete bind over how to deal with it. I suspect that things will get worse before they get better.
Thanks for reading. Have a happy Halloween.
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