A common question that arises at tax time is whether to itemize or take the standard deduction. For individuals paying the Regular Tax the decision is easy, but when the AMT is involved there is one extra step that needs to be taken. As will be seen in the example below, this step can save the taxpayer thousands in AMT dollars.
Annual election
The basic choice – itemizing vs. taking the standard deduction – is an election a taxpayer makes each year when the tax return is filed. The election is binding for both the Regular Tax and the AMT; a taxpayer cannot itemize for one and take the standard deduction for the other.
Itemized deductions
The major categories of itemized deductions are Medical and Dental, Taxes, Charitable Contributions, Home Mortgage Interest, Casualty Losses, and Miscellaneous. All of these are deductible under the Regular Tax. Under the Alternative Minimum Tax, however, the itemized deduction categories of Taxes and Miscellaneous Itemized Deductions are disallowed in their entirety, while Charitable Contributions are fully allowed. The categories of Medical and Dental, Home Mortgage Interest, and Casualty Losses also are allowed, at least in part.
Standard deduction
The standard deduction is a fixed dollar amount, adjusted annually for inflation. This may be taken in lieu of itemizing deductions. Currently this dollar amount is $11,400 for a married couple filing jointly.
Step 1 – compute the lowest Regular Tax
The Regular Tax, of course, is the starting point, and the choice here seems simple: if the standard deduction is greater than the taxpayer's itemized deductions, then the standard deduction will result in a lower tax liability. If the taxpayer is paying the Regular Tax, nothing more needs to be done. If, however, the taxpayer is in the AMT, it is critical then to go to step 2 to avoid overpaying taxes.
Step 2 – recalculate the tax liability using itemized deductions
Going back to our married couple, even though their itemized deductions were less than the $11,400 standard deduction, they need to recalculate their taxes taking itemized deductions instead of the standard deduction. Although this seemingly would increase their taxes, it may actually reduce their AMT, or even possibly even eliminate it as in the example discussed below.
Example
To illustrate how this analysis would work, assume a couple lives in Florida, a state with no income tax, and is renting their home so they have no real estate taxes or mortgage interest. All the couple has for itemized deductions is $10,000 of charitable contributions. They have $250,000 combined salaries and wages, and $50,000 of dividends and capital gains.
When this couple starts out with step 1, they note that their $10,000 of itemized deductions is less than the $11,400 standard deduction, so they elect to take the standard deduction. At first blush, this seems to be the correct thing to do because their taxable income is $1,400 less by doing this than if they had itemized, but in actuality this would be a very costly mistake for them to make.
Under these facts the couple would pay $64,634 in taxes - $61,610 of Regular Tax and $3,024 of Alternative Minimum Tax. Under the AMT, they receive no benefit from the standard deduction, and they are wasting the Alternative Minimum Tax benefit they could get from the $10,000 charitable contribution deduction. If, instead, in this example the couple elected to itemize, their tax liability would be $62,072 – all Regular Tax, with no AMT. Even though they gave us $1,400 in Regular Tax deductions, they saved $2,562 and completely eliminated the AMT!
Conclusion
It is critical that Alternative Minimum Taxpayers take this extra step. At first it may seem counterintuitive to be taking the smaller of itemized deductions or the standard deduction, but thinking differently can actually end up saving significant taxes.
