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Just when you thought you had the income tax game all figured out--maximize deductions to pay the least tax possible--you find out there's another set of rules that you may have to play by. A second tax system, supposedly designed to make sure that the very wealthy pay their fair share to Uncle Sam, now penalizes many middle-class Americans who legitimately reduce their tax liability below a certain level.

The goal behind the alternative minimum tax (AMT) when created in 1969 was a noble one--to prevent the rich from benefiting from so many tax breaks that they ended up paying no tax at all. The problem is that, unlike the regular income tax system, the AMT system has not been indexed for inflation, which means that more and more average taxpayers are reaching the earnings threshold for AMT every year. The Tax Policy Center, a nonpartisan group in Washington, D.C., predicts that, barring any major reforms, more than 30% or roughly one of three taxpayers could owe AMT in 2010, compared with about 4% in 2005. Married couples with adjusted gross income (AGI) between $75,000 and $100,000 and two or more children will be among those hardest hit. According to a report from the National Taxpayer Advocate's office, an IRS (Internal Revenue Service) agency that represents taxpayer interests, the average AMT taxpayer owed an additional $6,000 in tax in 2004. Those kinds of numbers should make every taxpayer sit up and take notice.

So, what can you do--once you regain consciousness--that might help you avoid, reduce, or at least prepare for AMT's bite?

How AMT works and whom it hits

The IRS describes AMT as "a separate tax computation that, in effect, eliminates many deductions and credits and creates a tax liability for an individual who would otherwise pay little or no tax." Under this parallel system, certain filers have to add back into their taxable income many of the most lucrative tax breaks (known as AMT "preferences"), such as state and local income and property taxes, some home equity loan interest, and dependent exemptions.

Whether or not you're a candidate for AMT depends on your income, your deductions, certain investments and financial transactions you make, where you live--even your marital status and how many kids you have. You can be subject to AMT because of one big entry on your tax return, or as the result of a combination of many small factors.

Key triggers that increase your odds of having to pay AMT include: Living in a state with high income, property, sales, and other taxes Having a lot of personal exemptions Claiming big miscellaneous deductions, such as high unreimbursed employee business expenses, union dues, investment expenses, tax preparation fees, or fees you pay an attorney Earning interest income from private activity bonds (issued for activities such as building a sports stadium), or investing in some tax shelters Large capital gains Exercising incentive stock options (ISOs) and not selling the stock in the year of exercise. (This is a key trigger, and potentially very expensive, because the difference between the exercise price and the fair-market value at the time of exercise is taxable under AMT--even if the value of the stock goes down.)

James Beavers, a Virginia-based tax attorney and CPA (certified public accountant), and the pro behind the AMT Advisor Web site, says that in his experience high personal exemptions--in other words, lots of kids--and residence in a high-tax state, such as New York or California, are two main triggers for AMT.

Of course, you can't tell just by looking at a list whether or not you will be subject to AMT. You have to run the numbers.

Find out if you're in AMT territory

"AMT can be a very unpleasant surprise," says Margaret Atkins Munro, a Vermont-based enrolled agent (someone who has passed a special examination or has experience as an IRS employee) and co-author of Taxes 2006 for Dummies. "Planning can really help someone on the edge to take some action [to soften the blow]." Before you can employ any defensive measures, though, you first have to determine whether or not you're vulnerable this year.

Munro says that if you've never been caught, or been close to being caught, in the AMT net, you probably don't need to worry about it now unless you had a major event that would drastically change your tax picture. That category might include such things as major medical expenses, the birth or adoption of multiple babies, the sale of incentive stock options, or a refinance of your home to pay for non-home-related expenses, such as your kid's college tuition.

A quick and easy way to tell if you have been approaching AMT territory is to check your completed Form 6251, Alternative Minimum Tax--Individuals from last year. Tax preparation software such as TurboTax automatically completes the form for any filer that meets the criteria for it. If a tax pro filed your return for you, he or she would have filled one out as well.

Compare the "tentative minimum tax" amount on line 33 to your regular tax liability on line 34 to see how close you were to paying AMT (remember, you pay the higher of the two results). If the gap between those numbers is small, if you don't have a completed Form 6251 to refer to, or if you have a very different financial picture now, you'll want to run a projection to see if you'll be hit this year.

Running the numbers yourself is not a simple task (see AMT Calculation sidebar)--Munro calls AMT "a professional tax preparer's nirvana because it adds such a level of complexity and obfuscation." Thankfully, there are a few resources that try to make the task as filer-friendly as possible for the many do-it-yourself taxpayers up to the challenge.

One of these is the spreadsheet calculator (or work sheet--use one or the other) provided at that AMT Advisor Web site. This tool can only tell you if you are not subject to the AMT. If it reveals that you may be subject to the AMT, you must fill out a Form 6251 to get the final verdict. (Find the forms you need at the AMT Advisor site or at IRS.gov.) You'll submit that completed form regardless of the outcome, because the IRS requires taxpayers who are close to AMT territory to prove that they are not subject to it. (Before you can tell if you owe AMT, you must always first calculate your regular tax using Form 1040.)

Be sure to read the list of exceptions provided with the work sheet. If you claim or have received any of the items on the list, you must fill out and file a Form 6251 even if the calculator or work sheet indicates you are not subject to AMT.

Another option, if you used TurboTax to complete last year's return, is to use the software's planning tools to predict your AMT liability. The first one is a What-If Work Sheet consisting of four columns, the first of which contains the numbers from your last return. You can use check boxes to have those numbers copied to the next column(s), and then manipulate the numbers to see how your tax liability would differ in various scenarios. (To access the What-If Work Sheet, go to the Forms menu, select Open a Form, and then select What-If Work Sheet from the list of forms.) Be sure to check the box that says Check box to use 2005 tax rates.

If you're doing all this with a pencil, check out IRS Publication 553, Highlights of 2005 Tax Changes, which includes updated proposed amounts for deductions and exemptions.

Access the second tool by choosing the Future Taxes tab from the top of the TurboTax window. Click Tell Me About Tax-Saving Tools, then Continue to Life Events Planner. From here you can choose from a list of events that would change your tax situation for the next year. You'll be given the opportunity to enter projected numbers, and to come back and choose a different life event to see how that would affect you.

If you'd rather chew on tin foil than try to calculate AMT on your own, then hiring a pro may be the best money you spend this year. Munro cautions taxpayers to hire someone who really knows AMT--preferably an enrolled agent or a CPA--so that you'll get useful information and advice, not just a completed form.

Limiting your AMT liability

If you're going to be hit with the AMT, the normal tax-planning strategies are reversed: Instead of deferring income and accelerating deductions, your new game plan should be to accelerate income and defer deductions.

Why? Because in a year when you're subject to AMT, all those coveted deductions (such as state and property taxes, miscellaneous deductions, and so forth) that are considered AMT "preferences" become worthless. And any income is going to be taxed at a flat 26% or 28% rate. If you're in a higher tax bracket under the non-AMT computation, income acceleration in an AMT year may, ultimately, save you money.

The AMT Planning sidebar offers strategies to avoid AMT or, if it's too late for that, things you can do before the end of the year to reduce your AMT liability as much as possible.

There is some good news: Mortgage interest on both your main and second homes is still AMT-deductible. And you still can use some popular tax credits to help offset the AMT you owe.

Also, certain items under the AMT system give rise to a credit you can claim in a later non-AMT year. You may be entitled to a credit if you had to pay AMT because you exercised stock options. Most of the other credits come from "timing" events (appearing on lines 13 through 26 on Form 6251), such as accelerated depreciation.

If you are claiming a credit, you need to file both Form 6251 and Form 8801, Credit for Prior Year Minimum Tax--Individuals, Estates, and Trusts every year after you pay AMT until you've claimed the entire credit.

The president and Congress are listening to suggestions from a special tax reform panel tossing around the idea of doing away with the AMT, or at least updating it so that it achieves its goal--keeping the wealthy from skating by tax-free--without capturing millions of middle-class Americans in its net. While it's very possible we'll see some changes to the system over the years, you shouldn't expect anything to happen in time to save you from AMT on your 2005 tax return. So, for now, be sure you understand how to play by both sets of tax rules.

AMT Calculations

The National Taxpayer Advocate breaks down the process of determining AMT (alternative minimum tax) liability into eight steps:

In a year when you're subject to AMT, all those coveted deductions become worthless.

AMT Planning

So, how can you turn the numbers in your favor when you have to pay AMT (alternative minimum tax)?

Try to time state, local, and property taxes to be paid in years when you won't face AMT. It may cost you less to postpone your tax payment to the beginning of the next year, even if you would have to pay a small late fee, than it would to lose those deductions in an AMT year. Conversely, if you expect to be subject to only the regular tax this year and the AMT the next year, your tax payments should be accelerated into this year if possible. Apply the same strategy to unreimbursed business expenses and miscellaneous deductions. Ideally, make an arrangement with your employer so that you don't have to claim business expenses as a deduction. Medical expenses still are deductible for AMT purposes, but only to the extent that they exceed 10% of AGI (adjusted gross income), rather than the 7.5% under the regular tax system. If you have some control over when you pay your medical bills, you can try to time them for a non-AMT year. Another strategy is to take advantage of a pre-tax medical cafeteria plan if your employer offers one. If you pay medical bills through the plan, the diverted income no longer is included in taxable wages, and the medical expenses no longer are itemized deductions. This could save you money under either tax system. Interest on a home equity loan is deductible under the AMT system only if you used the money to buy, build or improve your home. So if you're using home equity funds to pay for such things as a car, consumer goods, and school tuition, be sure that the terms are better than what you could get on a car loan, student loan, or other type of financing. Personal exemptions ($3,200 each in 2005) are replaced with one AMT exemption amount (see sidebar). OK, so you can't reduce the number of kids you have, but you may be able to arrange it so that dependents, such as college students, with modest taxable income, file their own separate tax returns claiming their personal exemptions. If you want to invest in tax-exempt bonds, consider ones that are not private activity bonds. Time your capital gains. There is a lot to consider tax-wise whenever you conduct a transaction that results in a large gain. A tax adviser can tell you if you'd be better off delaying the sale, spreading the gain over a number of years through an installment sale, or reporting the entire gain in one year. Before exercising (incentive stock options) ISOs, use tax planning software or consult a tax pro to calculate the tax consequences. To avoid or reduce AMT, sell the stock in the year of exercise, or spread the exercise over a number of years. Make a large cash contribution to your favorite charity. Unlike donations of appreciated stock, cash contributions are not considered an AMT preference item that is added back into your taxable income. Ways to accelerate income include taking prepayments of job earnings, withdrawing money from retirement accounts, realizing short-term capital gains, and redeeming Series EE U.S. savings bonds or certificates of deposit.

Preparation Softens Blow of Alternative Minimum Tax

How AMT works and whom it hits

Find out if you're in AMT territory

Limiting your AMT liability

AMT Calculations

AMT Planning