The AMT Donut Hole

In tax slang, a donut hole occurs when a subsidy or tax rate goes down, and then back up again.  The term entered the lexicon when the Medicare D prescription program was introduced.  Participants had their drug purchases covered for the first $2000 or so, and then had to bear all the cost for the next thousand or two of drug purchases, and then would again receive a subsidy once their drug purchases climbed past that point.

Yeah, weird. Ordinary taxpayers can only wonder, Who dreams up this stuff?

The AMT

Under the Alternative Minimum Tax, you calculate your tax two ways, the regular way and the AMT way, and then pay whichever is higher. For married couples with children, who own a home in a state with an income tax, the AMT is nearly inescapable once adjusted gross income (AGI) climbs over $200,000, through about $500,000.

Nearly every California or New York family in that income range falls prey to the AMT.  That’s because in that range, the AMT rate is not the stated rate of 28%, which doesn’t sound so bad, but 35%. The culprit: the phase-out of the AMT exemption, which adds 7 percentage points to the rate. Inasmuch as state taxes can be deducted from regular Federal income tax, but not AMT, the AMT, with its higher rate of 35%, and with no state income tax deduction, almost always comes in higher than the regular tax calculation. That’s why you owe it. The extra AMT tax owed can be substantial, as much as $10,000 more than regular tax for a family near the upper end of that income range.

For tax planning purposes—e.g., how much will a deductible expense save you in taxes—Californian AMT victims can assume a total tax rate of 44.3%, equal to 28% AMT + 7% AMT exemption phase-out + 9.3% state income tax (New Yorkers and others, please substitute your total state and local rate in place of 9.3%).  At that rate, a $24,000 contribution to a 401(k) plan only reduces your spendable income by $13, 368—the remainder represents taxes you would otherwise have paid to Uncle Sam and Uncle Cal.

The normal rule for AMT victims, then, is to take all the deductions you can find, because they are oh so very valuable; and if your journey through the AMT is a one-off—if most years, your income will not fall into the $200,000 to $500,000 range—then defer income however possible, to avoid that crushing 44.3% tax rate in the AMT zone.

This rule holds, unless you fall into the AMT donut hole.  Then the rule changes.

The donut hole above $500,000

In 2016, the AMT exemption is completely phased out at just under $495,000. After that point, a Californian family pays a marginal rate of 37.3%, equal to AMT of 28% plus state income tax of 9.3%.

That lower rate will obtain until income passes about $700,000, depending on the exact amount of mortgage interest, property taxes, and charitable deductions. Above $495,000, the regular Federal income tax applies at a higher rate than the stated AMT rate of 28%, as the taxpayer moves from the regular 35% to the 39.6% bracket.  As a consequence, the dollar burden of the AMT decreases with each increase in income above $495,000. The $10,000 peak AMT penalty gets whittled down and down as income climbs.

But, very important, the marginal rate, throughout this range, continues to be set by the AMT calculation.

After about $200,000 of additional income, the AMT calculation finally comes out to be lower than the regular tax, and from that point on, you no longer owe AMT. Accordingly, the AMT structure no longer determines your marginal rate. The Californian family’s marginal tax rate, above $700,000, will be 39.6% + ([1 – .396] * .093), or 45.2% (until they reach the higher state income brackets, whereupon the rate will climb a few percentage points more).

That’s the AMT donut hole: Californian couples pay 44.3% on AGI from above $200,000 through $500,000, and then 37.3% on income between $500,000 and $700,000, and then 45.2% on incomes above $700,000.

Implications for tax planning

The tax rate in the AMT donut hole, of 37.3%, is really quite low. To give you some perspective, a Californian family with taxable income of just $160,000 might pay a marginal rate as high as 34.7% (28% Federal + ([1-.28] * .093 state income tax). That rate is just 2.5 percentage points lower than in the AMT donut hole, where income is three to four times as great. Yes, weird.

More pointedly: a retired couple drawing $60,000 in social security, and $100,000 in distributions from a regular 401(k), corresponding to a 4% withdrawal rate against a portfolio worth $2.5 million, would also have a marginal tax rate of 34.7%.

Hammering the point: if you are an AMT victim earning several hundred thousands of dollars a year, and saving diligently and successfully for retirement, you are never going to owe income tax at a rate much less than 35%, while working or after retirement (unless you move out of California, or out of New York, etc.).

Your rate within the AMT donut hole is just a few percent more than that expected floor. That represents a tax planning opportunity.

Opportunity #1: Take extra income now

One member of our hypothetical couple earning about $500,000 may be a corporate employee whose compensation includes bonus, stock, options, or other non-salary elements. (This is particularly likely in California’s Silicon Valley or Manhattan’s financial district.) Generally, this couple will feel highly taxed, and their knee jerk reaction will be to hold off on cashing in stock or options for as long as possible.

The AMT donut hole suggests that would be a mistake. Far better to take up to $200,000 in discretionary income, right now this year, and fully utilize the low tax rate that applies in the donut hole. Conversely, once income hits $700,000, and the donut hole is exited, the traditional advice re-applies: no point in paying a tax rate above 45% until you absolutely must. Let the options run.

Opportunity #2: Cash out retirement savings early

Consider a couple a few years from retirement, with substantial 401(k) accounts, but cash poor. Suppose they decide to purchase a second home and / or remodel it to make it their retirement residence. If their income is right about $500,000, and they cashed out $200,000 in retirement funds, they’d pay a tax rate on that retirement distribution of just 2.5% more, than if they waited, and withdrew this amount during their well-funded retirement. Conversely, to borrow the funds as a constructions loan would cost them 4%, 5% or even 6% (construction loans, being risky, charge higher rates than plain vanilla mortgages).

This opportunity presumes ample 401(k) balances, whose distribution a few years hence is going to create an annual income, with social security, of more than $150,000 in today’s dollars (the current threshold for the 28% Federal bracket, and well above the threshold for the 9.3% California bracket).

Before you act

Although the AMT donut hole is real, and generally closes somewhere around AGI of $700,000, its exact end point depends on your particular situation. If you exit the donut hole at $650,000, in your very particular tax situation, but assumed you could go to $700,000, that last $50,000 is going to be taxed at over 45%, and mess up this whole strategy.

How AGI translates into (regular) taxable income, versus AMT income, is also highly variable. Hence, you can’t know where the donut hole ends, in your own situation, without running some numbers.

If you don’t have a professional to run the numbers for you, then take last year’s Turbo Tax file, and add (or subtract) ordinary income* until your AMT income (Form 6251) is exactly $500,000.  Note the tax calculation at the top of the screen; write down those dollar numbers.

*Do this by adding miscellaneous ordinary income (not investment or wage income).

Next, use Turbo Tax to simulate how your tax will change with changes in income. If you add $10,000, so that AMT income is now $510,000, your federal burden should increase $2800, and your California burden should increase $930. If so, that stretch falls completely into the donut hole.

Next, bring your AMT income up to $600,000.  Federal burden should now be $28,000 higher than in the initial, $500,000 scenario, and the California burden should be $9300 higher.

Next, bring your AMT income up to $700,000.  If your Federal burden is exactly $56,000 higher than the initial scenario, then the donut hole lasts through $700,000 for you.  If not, then you will have to range find to find the exact exit point, by testing $650,000, etc.

Doing this using last year’s Turbo Tax program gives a slightly conservative estimate of the ceiling on the donut hole.  This simulation also assumes that the rest of your tax situation remains roughly the same (no big changes in mortgage interest, charity, etc.)

Best wishes, as you navigate our ever more labyrinthine tax code.