These 7 AMT Questions Change EVERYTHING

Contrary to what you think, the Alternative Minimum Tax can actually be a really good thing.  But it can negatively increase your tax bill.  So is AMT good or bad? I'm going to ask 7 questions that can clarify whether AMT may be good or bad for your situation.

AMT is the ultimate oxymoron—Kind of like that kid at my high school whose last name was wimpy (he was 6 foot 5, and played in the NFL). The Alternative Minimum Tax is an oxymoron because it is not alternative—you have to calculate it.  And it’s not minimum because it's an additional tax that’s paid on top of your regular tax.  

But it can be a great thing because it can unlock these benefits: 

• Own Company Stock.  Oftentimes, AMT is the door you have to walk through to own company stock.  But the gains you may receive from stock ownership might outweigh the costs.  Especially if you leverage the second benefit AMT unlocks which is…

• Qualifying Disposition. In other words, receiving the LTCG tax rate on the bargain element when selling your stock. You can’t get there if you don’t pay AMT.

• Permanently reduce your tax bill while AMT is temporary. A third benefit of AMT is that it can be just a temporary tax as you have the potential to recoup the AMT you paid through receiving a tax credit later-on.  

But let’s not get too excited about the benefits, it is an additional tax after all.  So here are 7 questions you can ask yourself to understand if AMT may be good or bad.

Question 1 

Let’s get into the first question by looking at two tax rates.  32% vs 26%. Can you guess which one is the AMT tax rate? Reveal titles Now which tax rate would you rather pay?  AMT or ordinary income?  Great!  One more.  28% vs 24%. How about now? Which one would you rather pay? But in this case, the larger number is AMT.

What I just showed you is the paradox of AMT.  You don’t have to fully understand all of its complexities to know that AMT has the potential to be both good or bad.  I just showed you how.

Think about it, AMT’s tax rate may be smaller than your regular tax rate, in which case, triggering AMT would be beneficial because it could lead to savings on your overall tax bill.  So there’s definitely an opportunity for tax savings here.  On the other hand, if your ordinary income tax rates fall below 26%, AMT is probably a bad thing.   

So, question number one is: What is your current ordinary income tax rate?  

Sadly, the question isn’t that simple. We are in a progressive tax system. So if you earn an extra dollar that puts you in the 24% tax bracket, only that dollar will be taxed at the higher rate, while the prior earnings are still taxed at their lower rates.  So not only would I want to know your tax rate, but I'd also want to know how deep you are into that tax bracket. If you're deep into a high tax bracket, you’re more likely to get a benefit from AMT. On the flip side, if you just barely jumped from the 24% tax bracket to the 32% tax bracket, AMT as a lower tax rate probably isn’t worth it. 

But, there’s still one piece of the question that I didn’t include.

What are your current and future tax rates?  

Let me say something that will knock you off-center.  I want you to pay more in taxes this year.  That is, if it means a lower overall tax bill over time.  The goal isn’t just to lower your tax rate this year, but over the long-term.  And triggering more AMT might actually make sense—even if it means paying a larger bill this year. We can’t just look at AMT in a vacuum, but we need to zoom out and see how it will affect things over your whole ISO exercise schedule…most likely, several years at a minimum.  This will affect how you strategize around AMT.

It’s generally safe to say that if your current and foreseeable tax rates for the next several years are greater than 28%, AMT has the potential to be good.  If your tax rates are less than 28%, AMT is probably a bad thing.  But don’t come to any conclusions yet…there are more questions you should ask yourself.

Question 2 

One of the benefits of AMT largely depends on your answer to question number two.  Let me explain through this analogy  

Have you ever played the game tetris?  In the game, a random shape will drop down from the top of the screen and it’s your job to try and get it to fit.  Well, tax planning is like tetris.  Your income represents a random shape that drops down and it’s your job to try and get it to fit into place.  What if in tetris, you couldn’t shift the shape that comes down?  Well, you’d lose pretty quickly.  

Utilizing AMT as a tool to lower your tax rates largely depends on your ability to shift your income. The idea here is to earn your income, while paying a lower tax rate than what you’d normally pay.  In other words, get while the getting is good. For example, those who are in the higher tax brackets have the ability to decrease their tax bill if they can accelerate their income into the same year they pay AMT. 

One can do this through NSOs exercises, ESPP sales, Roth conversions, sales commissions, and so on.  For example, if you were going to exercise your NSOs at your 37% tax rate, just know that you may be able to do it at AMT’s 28% instead—saving you 9% on taxes. But don't take action yet… this has to be a part of an overall plan as these income shifting tools could help expedite the return of the AMT credit too.  In theory, if AMT is a good thing for your situation, you generally want to accelerate your income to the point where you're not paying much AMT.   That’s a discussion for another day, but think about your income.  Is it just a salary or is there other complexity to your income such as NSOs, real estate income, etc?  That is why question number 2 is…  

Can you shift your income?

If you have the ability to shift income, then AMT could be a good thing.  If not, AMT is probably less favorable.  

If you’re finding value in this, please share this with others who may be subject to AMT. Now here's an unsolicited joke about AMT:

When asked if the glass is half full, or half empty…The tax planner said it's A EMTY (AMT) glass. Okay, I made that one up. That was bad.

Question 3 

If you don’t nail question number 3, then you’re increasing your risk of causing a financial crisis.  This next question helps us understand whether or not you can wiggle out of your AMT bill.   

Imagine that you exercise your ISOs at the beginning of the year, triggering AMT. In the summer, something terrible happens financially—like some unexpected expense comes up that depletes your savings.  You can no longer afford AMT.  Not all hope is lost, but you need to act quickly! The trick to avoiding AMT is to sell your stock before the end of the tax year. Typically, if you buy and sell in the same tax year, you don’t pay any AMT.  This is called disqualifying disposition.  But there’s one major gotcha here.  If you can’t sell your stock, then you’re stuck with that AMT bill.  For example, when a company is private or in a lock-up or blackout period, you may be unable to sell before the end of the tax year.  

That’s why “Is your stock liquid?”  is question number 3

I could have asked if your stock was public or private, but some private companies may have liquidity events for their employees.

The liquidity of your stock options can really complicate financial planning and tax planning.  Yet, this could be worth tens of thousands of dollars in tax savings, so if you'd like to work with a professional, my firm specializes in this.  More details in the description below. (less intrusive: More information below)

For those whose stock is liquid, then AMT is potentially good.  If the stock is not liquid, then AMT comes with greater risks.  

Question 4

Question number 4 will help you avoid a big AMT mistake that I’ll explain through this hypothetical situation.  Let’s say you were to exercise on December 31st and one day later, you sell those shares on January 1st. Bad move! Similar to the last example…You know how I said that if you sell in the same tax year that you bought, you don’t have to pay AMT? Well, in this hypothetical situation, you sold in a different tax year than you bought…so you must pay AMT. What’s worse, because you sold within a year of buying, you also triggered disqualifying disposition which means paying the high STCG tax rate on the gains. You got the worst of both worlds.

Generally speaking, if you’re going to pay AMT by not selling in the same tax year as you bought the stock, then you should at least consider holding for the advantageous LTCG rates that come with qualifying disposition.  That said, sometimes there’s a looming expiration date on the stock option or some other unique circumstance that warrants selling earlier.

So that is why I like to ask this question, question number 4:, “how long will you hold the stock?”

If you plan on holding for the long-run, then yes, AMT has the potential to be good because it is the door that you have to walk through to get to the advantageous LTCG rates through qualifying disposition.  If you don’t plan to hold your stock for the long-term, AMT is probably bad.  

One more consideration when you're holding for the long-term is if being over concentrated in your company’s stock is worth the risk? 

Question 5

Question number 5: Are you human?

If so, then this is not intended to be a substitute for individual specific legal, tax, or investment advice. Your personal values, goals, and other circumstances may render some or all of this information inaccurate. As such, I’ve been avoiding definitives (like always, and will) because of these many variables.  These 7 questions are not an all-inclusive list, nor will they perfectly predict AMT's outcome. Sorry, I had to squeeze that in there for your own safety.  Here's the real question…

I’ll share a real life example of what happens if you don’t ask this question early on.  But first, 

You need to know that we humans have a risk spectrum which helps us make decisions about risks and if they’re worth taking.  Let’s look at cliff jumping for example.  The reward is 2 seconds of free falling, and the risk is shattered bones…or death.  Is that a risk worth taking? No! Not at all.  I’ll answer that for you.  That is not a risk worth taking.

When it comes to your stock options and AMT, we're dealing with an investment—which has risks. Are you able to stomach these risks?

I met someone whose story is the reason why we need to address question number 5.  He exercised when the stock price was super high—creating a large AMT bill. But by the time he needed to pay that AMT bill, his stock flopped terribly.  He didn’t have the funds from the stock proceeds to pay the massive AMT bill.  It was devastating!  He had to sell his home, move, and was nearly suicidal.  This isn’t a one-off experience either, but has happened to many people.  

So that is why I like to ask question number 5, which is: what is your risk tolerance and capacity?  Risk tolerance is your willingness to take on risk emotionally. Whereas risk capacity is your financial ability to take on risk. Can you afford for the stock to lose its value?

If your risk tolerance and capacity are high, then AMT could be potentially beneficial.  If your risk tolerance or capacity is low, then AMT is probably a bad thing. 

Question 6

Question number 6 really forces people to examine their finances and decide what they value.  It comes down to determining what you want to do with your money.

Earlier in this video, I mentioned how you can get the advantageous LTCG tax rates on the bargain element when you achieve Qualifying Disposition. But how do you actually get there? In order to achieve qualifying disposition, you must wait to sell the stock until at least one year from the date of exercise and two years from the date of grant has passed. The implication is that you can’t buy and sell in the same tax year, so you’re more likely to trigger AMT.

Question number 6 is: What's more important to you, quick access to cash or the best tax rate?  If you’re there for the best tax rate, then potentially AMT’s a good thing because it gets you one step closer to qualifying disposition.  On the other hand, if you’re saving for something specific like a down payment or a masters degree, then maybe you need quick access to cash.  Holding the stock for the long term and triggering AMT, might not align with your liquidity and cash needs.  

Question 7 

On to question number 7.  If you suspect you might trigger AMT, you’ll definitely want to be aware of this: Incentive Stock Options are considered a deferral item. When you exercise them, you’ll likely pay AMT, but you have the opportunity to get that money back through a future tax credit.  In this case, AMT is ultimately more about the timing of your tax payments than it is about paying an extra tax.  Therefore you can think of AMT as a temporary thing that can permanently reduce your taxes for two specific years—first, the year in which you accelerate income, and second, the year in which you recoup your AMT credit. Let’s dive into this a bit.  

In the year you pay AMT, you can accelerate your income to take advantage of AMT’s 28% tax rate rather than paying a higher, 37% tax (if applicable). What’s more, in the year you take the AMT credit, you are reducing your tax liability which could potentially save that year’s income from being taxed at 37%.  Thus, the AMT credit can be extremely effective at reducing your tax bill in the short term and the long term. 

And that’s why question number 7 is…Are you patient and willing to wait?

If you’re IMpatient, then AMT is probably bad.  If you’re patient then AMT can potentially be good.

Did you know that getting the full AMT credit can take many years?  I’ve found it’s very difficult to get any more than $4k-$8k per year of credit back—even with lots of financial resources and flexibility.  Note, this is under current tax law which may be changing in a few years.

The longer it takes to get your credit back the less valuable it becomes. My grandfather was able to buy a hamburger  (or as my son says, “Hang Gerbur”) for 15 cents.  It’s no secret that 15 cents can’t get you what it used to.  Likewise, as your salary and inflation continue to grow, the once-valuable AMT credit won't cover the same percentage of your taxes. Say that you have a $50k credit. That could equate to half of your salary today, but only a quarter or less of your future salary. So if this credit is going to take multiple decades to get back—which it very well could—it might not be worth it.

This is showing how long-term you need to be thinking—not only with AMT, but also the AMT credit. You also need to be aware that sometimes AMT is permanent and there is no credit.

So how do you get the AMT credit back?  And how do you get it back faster?  If you want to know how the credit works, read this……….Or if you want to avoid AMT, read this.