Alternative minimum tax may not be so alternative

Question: Each year my tax consultant offers explanations on why my tax bill is so high, and inevitably the discussion includes alternative minimum tax. I don't get stock options from my practice or any other outside sources, which I understand is a large player in the AMT calculations, so why do I owe this tax?

Answer: I don't blame you for being frustrated with your position of owing alternative minimum tax. The tax's claws are far-reaching to the point where many taxpayers who weren't intended to be assessed for the tax when the law was originally drafted are now finding themselves with a significant AMT bill.

AMT provisions were enacted in 1970, when there were extremely wealthy households that had paid no tax the prior year.

The Brookings Institution, a Washington-based think tank, noted in a report last year that 1 million households were affected by AMT in 1999. If the current law does not change, 33 million households will be affected by 2010 -- making AMT "as common as the mortgage interest deduction today." Brookings estimates that 93% of households earning between $100,000 and $500,000 would be hit with AMT.

Every taxpayer is allowed an exemption or deduction of $40,250 (single) or $58,000 (married) against AMT. As your income increases, the exemption amount is reduced or phased out.

And income doesn't just mean what you take home from work. Look at long-term capital gains. Although they receive the same low preferential income tax rate under the AMT calculation as they do regular tax, they also increase your income for purposes of assessing AMT. If you sell stock each year at significant capital gains, there is a good chance you will be liable for AMT.

Think about reducing your capital gains by selling loser stocks or spreading your capital gains over several years.

If you pay high state and local taxes, then you could fall under AMT. That's because although allowable for regular tax, state and local taxes are not deductible for AMT. This includes state and local property taxes, sales tax and income taxes.

There is nothing you can do about the AMT disallowance for mandatory state taxes, but you could try to avoid the bunching of the deduction by paying expenses evenly between years, and avoid owing state income tax on investment income by investing that money in home-state municipal bonds, which are tax-exempt.

Question: I am thinking of either taking distributions or borrowing from my retirement funds to pay off credit cards, ease the kids' college tuition burden or potentially make some home improvements. Do you think that is a good idea?

Answer: Most tax advisers warn their clients not to take distributions from retirement funds until they are 59½ years old, so they can avoid the penalty tax for early distributions. Federal and state ordinary income tax will be owed on the distribution, as well as a 10% extra tax for early payment. This can be an expensive source of money.

Look to your personal savings to determine if those funds are accessible. If so, they are perfect for paying off credit cards or paying college tuition with no associated tax costs because they are "after-tax" dollars.

If personal savings are at a minimum, consider borrowing funds from your medical practice retirement plan. Even if your plan allows loans, however, there are strict guidelines for the maximum amount of a loan, and the loans might have repayment and interest terms that might not be feasible for your cash-flow situation.

If loans or personal savings aren't options for you, then early distributions from retirement funds can be pursued. Federal and state income taxes must be paid, but there are ways to avoid the 10% penalty. For example, if the distribution is part of a series of substantially equal periodic payments, then the 10% penalty will not apply. To be eligible for this exception, payments must not occur less frequently than annually.

Another exception to the 10% penalty tax, which would be applicable in your case, would be using funds for family higher education expenses or for a first-time home purchase. Unfortunately, these exceptions only apply for IRA distributions and not employer plan distributions, so be careful to choose the right source of retirement funds for making distributions.