Taxed by Surprise

Tuc

ked inside the 2005 budget from the Bush Administration is a proposal that may prompt you to sigh with relief if you have feared being hit with the alternative minimum tax (AMT). It's a patch — not a full-strength remedy — for a complicated tax that was designed to prevent the wealthy from avoiding taxes but is increasingly hitting the wallets of middle-class taxpayers.

According to current law, taxpayers must calculate their taxes two ways — under the regular federal income-tax schedule and under the alternative-tax scheme — and pay the higher of the two. About 2.4 million taxpayers will be subject to the AMT this year, says Nina Olson, the IRS's National Taxpayer Advocate, who heads an independent office created to address taxpayers' problems. The way the AMT law was written, the tax will apply to more and more taxpayers — an estimated 30 million by 2010. Says Olson: "It's a time bomb."

The reason for the explosion in the number of Americans subject to the AMT is twofold: unlike regular federal and state income taxes, the alternative tax has not been indexed for inflation. Also, tax cuts in 2001 and 2003 decreased the income-tax burden for many Americans and triggered the alternative tax, which eliminates many deductions and credits.

"The average family of four earning $50,000 to $75,000 a year can very likely be subject to alternative minimum tax for reasons they would never expect," says Barbara Raasch, a CPA and partner at Ernst & Young. Deducting property taxes in a high-tax state, like California or New York, can push you into the AMT. The same is true of many other deductions, such as state income taxes, medical bills and business-related expenses.

Congress put a Band-Aid on the problem by increasing AMT-exemption thresholds in 2001 and then again in 2003, but those higher limits are set to expire at the end of this year. The new Bush budget proposal would offer a reprieve — extending those higher thresholds and the provision that allows certain personal credits to offset the AMT — but only through 2005.

Meanwhile, in order to avert the AMT bite, you may have to reverse your regular tax strategy and forgo taking advantage of many itemized deductions. For example: you should consider refraining from prepaying state income taxes or real estate taxes, and don't defer bonuses or other income to the next year. And you should run the numbers before tapping any long-term capital gains. Finding the triggers can be tricky, so you may want to consult an accountant or visit websites like turbotax.com.

Epperson is the personal-finance correspondent for CNBC