For many years, the alternative minimum tax (AMT) posed a risk to many taxpayers in the middle- to upper-income brackets. The Tax Cuts and Jobs Act (TCJA) took much of the “teeth” out of the AMT by raising the inflation-adjusted exemption. As a result, middle-income earners have had less to worry about, but those whose income has substantially increased (or remains high) should still watch out for its bite.
The AMT was established to ensure that higher-income individuals pay at least a minimum tax, even if they have many large deductions that significantly reduce their “regular” income tax. If your AMT liability is greater than your regular income tax liability, you must pay the difference as AMT — in addition to the regular tax.
As mentioned, the TCJA substantially increased the AMT exemption for 2018 through 2025. The exemption reduces the amount of AMT income that’s subject to the AMT. The 2020 exemption amounts are $72,900 (for single filers), $113,400 (for married joint filers) and $56,700 (for married separate filers).
AMT rates begin at 26% and rise to 28% at higher income levels. That top rate is lower than the maximum regular income tax rate of 37%, but fewer deductions are allowed for the AMT. For example, you can’t deduct state and local income or sales taxes, property taxes and certain other expenses.
The AMT exemption phases out when your AMT income surpasses the applicable threshold, so high-income earners remain susceptible. However, even some taxpayers who consider themselves middle-income earners may trigger the AMT by exercising incentive stock options or incurring large capital gains.
For example, because the exemption phases out based on income, realizing substantial capital gains could cause you to lose part or all of that exemption and, thus, subject you to AMT liability. If it looks like you could get hit by the AMT this year, you might want to delay sales of highly appreciated assets until next year (if you don’t expect to be subject to the AMT then) or use an installment sale to spread the gains (and potential AMT liability) over multiple years.
Also, be aware that claiming substantial itemized deductions for expenses that aren’t deductible for AMT purposes used to be a major risk factor for falling into the AMT net. However, because the TCJA limited or eliminated some of these deductions for regular income tax purposes (such as the deduction for state and local taxes and miscellaneous itemized deductions subject to a 2% of adjusted gross income floor, respectively), this is now much less of a risk.
Since passage of the TCJA, the AMT may have become an afterthought for many people. However, it’s still worth a look to see whether it could create undesirable tax consequences for you. Please contact us for help assessing your exposure to the AMT and, if necessary, implementing appropriate strategies for your tax situation.
College savings showdown: 529s vs. Roth IRAs
Many people assume that a 529 plan is the ideal college savings tool, but other vehicles can help parents save for college expenses, too. Take the Roth IRA, for example. Whether you should use one or the other (or both) depends on several factors, including how much you intend to contribute and how you’ll use the earnings.
A 529 plan allows participants to make substantial nondeductible contributions — up to hundreds of thousands of dollars, depending on the plan and state limits. The funds grow tax-free, and there’s no tax on withdrawals, provided they’re used for “qualified higher education expenses” such as tuition, fees, books, computers, and room and board. Other qualified expenses include up to $10,000 of primary or secondary school tuition per student per year and, new under last year’s SECURE Act, up to $10,000 of student loans per beneficiary. If you use the funds for other purposes, you’ll generally be subject to income taxes and a 10% penalty on the earnings portion. Some 529 plans are also eligible for state tax breaks.
Roth IRA contributions also are nondeductible and grow tax-free. And you can withdraw those contributions anytime, tax- and penalty-free, for any purpose. Qualified distributions of earnings — generally, after age 59½ and more than five years after your first contribution — are also tax- and penalty-free.
Advantages and drawbacks
The main advantages of 529 plans are generous contribution limits and the ability to accept contributions from relatives or friends. Roth IRAs, on the other hand, are subject to annual contribution limits of currently $6,000 ($7,000 if you’re 50 or older). So, even if you and your spouse each set up Roth IRAs when your child is born, the most you’ll be able to contribute over 18 years is $216,000 (not taking into account any future inflation increases to the contribution limit). Additional drawbacks are that you must have earned income at least equal to the contribution, and you can’t contribute to a Roth IRA if your adjusted gross income exceeds certain limits.
Funds in a 529 plan that aren’t used for qualified education expenses will eventually trigger taxes and penalties when they’re withdrawn. However, with a Roth IRA, you can use contributions, as well as qualified distributions of earnings, for any purpose without triggering taxes or penalties. This includes items that wouldn’t be qualified expenses under a 529 plan, such as a car or off-campus housing expenses that exceed the college’s room and board allowance. Plus, if you don’t need all your Roth IRA funds for college expenses, you can leave them in the account indefinitely.
Before selecting a plan, consider your overall financial, retirement and estate planning goals. Our firm can help.