Will The AMT Eat Your Tax Break?

With great fanfare last year, President Bush and Congress agreed to slash the tax on both dividends and long-term capital gains to 15%. There's just one problem: Hundreds of thousands of upper-middle-income investors will never enjoy those low rates. Indeed, some may be paying higher taxes on gains than they did before the law was changed. Forget 15%. Think effective tax rates ranging from 21.5% to 23%.

The culprit? The alternative minimum tax, of course. The AMT steals the benefit of lower dividend and capital-gains rates from investors with total income between, roughly, $150,000 and $400,000. Perversely, the super-rich -- with investment income approaching $1 million -- are much more likely to pay something close to the advertised 15%, rather than the hidden higher rates.

Capital gains and dividends are not direct targets of the AMT. But the extra income you earn from investments can throw you into the alternative tax. As a result, the effective rate on those investments -- the amount you actually pay -- changes dramatically as your returns increase. First they rise sharply, then they fall.

In a new study published in the journal Tax Notes, Wake Forest University business professors Yvonne L. Hinson and Ralph B. Tower put numbers to the problem. Hinson and Tower took a family with an adjusted gross income of about $178,000, then gradually increased the amount of capital gains it received. With income of $178,000 and no gains, the family pays no AMT and no capital-gains tax. Add $100,000 in gains, and the same taxpayer owes an extra $21,495 in tax, including $3,264 in AMT -- an effective tax rate on those gains of 21.5%, much higher than the advertised 15%.

But add $1 million in gains, for a total income of $1,178,000, and the AMT flattens out at about $9,000. Because that is such a relatively small amount for someone making more than $1 million, the effective tax on those gains drops to just 16.58% -- close to the official 15% rate. "It's almost a bell curve," says Hinson. "At lower incomes, you are O.K. Then your tax goes up, then it falls again. This is not the spirit of the law."

While her study only looked at capital gains, Hinson says the same thing happens with dividend income -- also taxed at 15%. Leonard E. Burman, a tax economist with the Urban Institute, agrees. But he says Hinson and Tower may be underestimating the effective rates on gains for upper- middle-class taxpayers. He figures the rates for some of them could actually approach 23%. Whatever the exact rate, one thing is sure: Unless the AMT is fixed, lots of investors will be in for another April 15 shock.

By Howard Gleckman

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE