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Lesson in Course: Finance at work (advanced, 5min )
What is alternative minimum tax and how does it affect us?
Alternative minimum tax or AMT is a floor set by the government on the percentage of taxes we must pay to the government, no matter how many deductions or credits the filer may claim. AMT was designed to prevent rich taxpayers from escaping their fair share of taxes owed through tax breaks. The complicated thing about AMT is that it often doesn't apply to everyone. However, it does apply to incentive stock options.
AMT is only calculated for folks who earn above a certain annual income, the AMT exemption.
For the tax year 2020, the AMT exemption for individual filers is $72,900. For married joint filers, the figure is $113,400. For the tax year 2021, the figures are $73,600 for individuals and $114,600 for couples. That means we could be on the hook for AMT if we earn more than the exemption numbers.
We can be at risk of triggering AMT or alternative minimum tax when we exercise ISO grants.
As a refresher, if we have ISO grants that qualify, we typically do not have to pay taxes on exercising. Instead, that tax is deferred to capital gains tax when we sell our shares. However, there is a caveat. AMT is calculated separately from our regular income tax and will kick in if the amount calculated is substantially more than our income tax.
The potential AMT tax is calculated based on the difference between the stock's current fair market value (FMV) at the time of exercise.
AMT has prevented people from being able to leave their jobs.
AMT tax was imposed to close certain loopholes for the ultra-wealthy to avoid paying taxes; however, it also affects lucky startup employees who find themselves in very successful companies.
The term golden handcuffed describes when employees are unable to pay the tax to exercise their options and thus can’t leave the company. For example, early UBER employees couldn’t leave the company because the FMV of Uber stock had increased in value due to private investors, and the big price difference triggered AMT for everyone. If they wanted to quit, they would've had to forfeit the very valuable stock that they could not afford to exercise.
For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!
Even though we can estimate the AMT reported, complex rules are in place that determine if it will actually be applied. For many of us, simple tax software like Turbotax only help with knowing if our deductions trigger AMT. A tax advisor is needed to determine how much of our options we can exercise before triggering AMT. Alternatively, we can get ahead of AMT by early exercising. Be sure to read the Archimedes lesson on early exercising.
If we find ourselves golden handcuffed, a few financial institutions provide loans for employees to cover exercise tax. However, these loans can be expensive, and there is a risk to exercising that we need to think through.