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Incentive Stock Options: Alternative Minimum Tax Explained!

If you have Incentive Stock Options (ISOs), then you also have to think about the Alternative Minimum Tax (AMT). Otherwise, you may be in for a surprise when you file your taxes!

Before we get too far into this, it's important to understand the basics around incentive stock options and the way they're taxed. I did a previous video that talks about that so it would be helpful to watch this one first: 

 

Once you've watched that one, then I would encourage you to then come back to this one:

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By Mike Zung

AMT credits: What they are and how they work

There's one final thing that's really important, and it's called the AMT credit. In this scenario, whenever you've exercised stock options, and it's caused you to have AMT, this amount can get used as the AMT credit.

Generally, the way that the AMT credit works is that in future years, whenever you're not exercising ISOs, you're still doing these two calculations. In the years that your regular tax is higher than your AMT, your alternative minimum tentative tax, then you can actually use some of this credit to lower your next year's income. 

Now it's not as super straightforward as just saying, "Okay, you can just take that $5,000 and get it all back the next year." So it's possible that it takes multiple years to get that credit back. But the nice thing is that this credit never expires, and so you're able to carry it forward indefinitely until you use it all up.

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The regular tax system

I think the best way to explain AMT and the way that it works is to first walk through the way that your regular tax calculation works.

  1. At a high level, you take your gross income, so you just think of that as the money that you make, and then you subtract out any adjustments, which would be things like student loan interest or HSA contributions, or regular IRA  contributions. 
  2. Then your gross income after your adjustments gives you adjusted gross income. 
  3. After that, you subtract out deductions, so that would either be your standard deduction or if you itemize, then that's whenever this gets taken out.
  4. Then that number gives you your taxable income. So with your taxable income, this is where the normal math happens where the first bit gets taxed at 10%, then you multiply the next by 12%, and you go up the tax brackets from there. 
  5. After you do that math, that gives you something called your tentative tax, which then you subtract out credits, so if you have kids, then that's whenever the credits get taken out. 

The final number that you get is called your total tax, and that's just how much you owe in taxes.

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The alternative minimum tax system

So with this regular system, what was happening is that there were certain scenarios where people were actually making a lot of money but were able to use this system in a way where they actually didn't have to pay a whole lot in taxes. So in the '60s, the government said, "Hey, we need to figure out a way to close these loopholes." So what they did was they created a whole parallel tax system, and they called that the alternative minimum tax. 

Now let's do a real quick version of how the alternative minimum tax works. 

  1. The way that it works is that you take this taxable income number here, and then you drop it into the top of the AMT calculation. 
  2. Then they say, "Hey, let's add back either the standard deduction or if you itemize, then add back some of it." So it'll add back like state taxes and local taxes. 
  3. Then you also add these other things called adjustments and preference items. I put a star here because of what I talked about before with that ISO bargain element, and that's where this gets added here. So that's why you can trigger AMT with your ISOs because there's income here that isn't included in this formula at all. 
  4. Once you add those back, then there's just this flat amount that you subtract out called the exemption, and then that will give you your alternative minimum taxable income. 
  5. Similar to the regular tax system, this is where you do the math again, and you multiply it by the tax rates here, although there are just two tax rates with AMT. Then that will give you another number for tentative tax. 
  6. The last thing that you do is compare your tentative tax on your regular return against your tentative tax in the AMT system. Whichever one is, the higher one is the one that you're going to pay.  

Let's walk through this with our example. Let's say that in the regular tax system that whenever we go through this that we get to here, and then our tentative tax is $30,000. But since we exercise some ISOs and we've carried them over through the year, then that bargain element gets added here. So we'll just say in our same example that we run through this parallel calculation, and then our tentative tax here comes out to $35,000. Whenever this happens, then you pay whichever one is the higher one. In this scenario, you would pay the $35,000 dollars, and the way that they would do that is they would just add another five thousand dollars underneath the tentative tax here, and that would be your $5,000 of AMT.

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How to plan for AMT

Now let's talk about some of the planning opportunities with this. 

The first one is if you know that you're going to be exercising ISOs, then you want to know what this number is going to be because otherwise, you could get really surprised by the amount of AMT that you would expect to owe, and you don't want to be caught off guard with that. You'll probably need a tax professional or a financial professional that understands this information to be able to help you with that, but it's good to know that just so that you're not caught off guard. 

Then the second planning opportunity is there's actually a way that you can exercise stock options without having to pay any AMT. So let's break this down real quick. Every year you're actually doing both of these calculations; you just might not know it. But in a normal year, whenever you don't have any of these kinds of special things here, then this tentative tax on your normal taxes is higher than your AMT tentative tax. 

So let's just say in our example that we have $30,000 on your normal taxes, and then the AMT tentative tax without any of these adjustments is $20,000. Well, what that's saying is that you can actually start exercising some amount of ISOs, and you can increase the AMT tentative tax but make sure that it doesn't go over the normal tentative taxes. That way, you can actually do an exercise without paying any sort of AMT.

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AMT and the ISO bargain element

What we're talking about here with AMT, it's about exercising your options and the bargain element. So I'll do a quick explanation of what that is.

If we walk through an example kind of similar to what I did in the last video, assume that we have been granted 1,000 ISOs, and it has a $10 strike price or exercise price. Then, whenever you actually exercise it, you take the difference between the price, the strike price, and the actual value of it that day that you exercise it. So in our example, we have $50, and the strike price is $10, so then the difference between those two is $40 per share. You multiply that by the 1,000 ISOs that we just turned into stock, and that gives us $40,000 dollars. That is called the bargain element.

In the last video, I talked about how if you exercise here and then you wait more than a year before you sell it, then there are some tax benefits to that. With the bargain element here, the reason why I'm pointing it out is that if you exercise in a year, but then you don't sell within that same calendar year, then this bargain element gets plugged into the alternative minimum tax calculation.

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