The greater the spread between the exercise price of your ISOs and the fair market value of the stock when you exercise, the more likely you’ll generate some amount of AMT to pay. The difference in that spread is commonly known as the bargain element.
It’s an important factor in determining if you have an AMT bill — but it’s not the only determinant. A less discussed, but also important factor is your income.
To understand how your income impacts how much AMT you may owe, you need to understand how, when, and why AMT is triggered by your decisions with your incentive stock options.
First, Figure Your Regular Tax Rate
To fully understand AMT, you have to take a step back and look at how to calculate two taxes under two separate calculations: the regular tax and tentative minimum tax.
You’ll want to understand what these figures look like before you factor in something like an exercise and hold of incentive stock options. This gives you a “base-case”’ scenario to work with, which can help you in evaluating how you may be impacted by the AMT.
In fact, the difference between the two tax calculations directly impacts how much AMT you may owe, how many ISOs you may be able to exercise and hold and not pay AMT, and how it much (and how quickly) you may receive an AMT credit.
Regular tax refers to the amount you owe in a normal year of earning ordinary income. Very broadly speaking, you can calculate the regular tax you owe by:
- Starting with your adjusted gross income
- Subtracting the standard deduction from your adjusted gross income (which is $24,800 if you’re married filing jointly in 2020) or itemized deductions (if you itemize) to calculate your taxable income
You can then multiply your taxable income by the appropriate tax rates to figure the actual amount you owe for regular tax. In 2020, the tax rates that apply to various levels of income if you are married filing joint are 12%, 22%, 24%, 32%, 35%, and 37%.
To see how this works in real life, let’s look at the example of a 50-year-old couple. They’re married filing jointly (MFJ) and take the standard deduction. If they’re both W2 employees with a gross income is $250,000, we can subtract the standard deduction of $24,800 — which equals $225,200 in regular taxable income.
To determine the specific amount of taxes they owe, we need to apply the appropriate tax rates to this taxable income:
- 10% tax on the first $19,750 of taxable income
- 12% on taxable income from $19,751 – $80,250
- 22% on taxable income from $80,251 – $171,050
- 24% on taxable income from $171,051 – $225,200
This brings the couple in our example to a total regular tax owed to $42,207.
How to Calculate the Tentative Minimum Tax and Your Alternative Minimum Taxable Income
Next, we need to calculate the tentative minimum tax to get a full base-case scenario before looking at how gross income may impact your sensitivity to the AMT.
To do so, we start with the taxable income from the regular tax calculation. We’ll then back certain items to figure the alternative minimum taxable income (AMTI).
The items commonly added back include the standard deduction (if you take that option) or the tax portion of your itemized deduction (if you itemize), and the bargain element from an exercise and hold of incentive stock options.
The bargain element is figured as:
Bargain Element = Shares Exercised x (Fair Market Value at Exercise – Exercise Price)
If we return to our couple above, you’ll remember their taxable income was $225,200 and they took the standard deduction. We need to add back $24,800 for the deduction in order to calculate an AMTI; doing so gives us $250,000.
Next, we’ll subtract the allowable exemption to arrive at an alternative minimum tax base. In 2020, the allowable exemption when married filing jointly is $113,400.
The alternative minimum tax base is multiplied by 26% up to $197,900 (for married filing jointly in 2020) and 28% in excess of this amount. The result of this calculation provides the tentative minimum tax amount.
Continuing with the numbers we’ve been working with, if the AMTI is $250,000, we then subtract the allowable exemption of $113,400. That gives us an AMT base of $136,600.
We can then apply tentative minimum tax rates to this figure, which are as follows:
When we apply these rates, we can see that the total tentative minimum tax equals $35,516.
If your tentative minimum tax is lower than your regular tax, you won’t owe AMT. This is what happened in the above example we’ve been working with so far; the regular tax owed was $42,207. Because it’s higher than the tentative minimum tax, our couple would not owe AMT.
But if your tentative minimum tax is higher than your regular tax, you will likely owe AMT. AMT is equal to the amount your tentative minimum tax exceeds your regular tax.
A Side Note on the Tax Rates for the Tentative Minimum Tax
While it appears that only two tax rates exist for the TMT, when you calculate the actual tax owed at various levels of gross income, you can see that the situation is more complex. This is an important distinction that will be useful when evaluating how to use the spread between the TMT and regular tax.
Instead of two simple 26% and 28% tax brackets, the average tax looks more like 0%, 26%, 28%, and 35%. This happens because of:
- The allowable exemption: The first $113,400 of your AMTI is not subject to tax, per the allowable exemption. In this income range, your AMTI is $0. So even though you are in a 26% marginal AMT bracket, the actual tax as calculated is 0%.
- The exception phaseout: When your AMTI exceeds $1,036,800 (MFJ), you begin to lose your exemption. This occurs at a rate of $1 lost for every $4 in excess of $1,036,800. In this phaseout period, the result of the lost exemption is seemingly a 35% tax. In actuality, the calculated rate is the 28% marginal rate.
This chart represents the 26% and the 28% marginal AMT rates and the “actual” tax rates by income segment. Driven by the exemption, your actual AMT rate is 0% at lower income levels. As your income rises, you’ll hit the standard 26% or 28% rate until you reach the phaseout.
When you do reach that point, the tax rate increases to 35%. Then, you drop back down to 28% after the full exemption is phased out.
Comparing the Regular and Tentative Minimum Tax Spread at Different Income Levels
Once we understand how the regular tax and tentative minimum tax are calculated, we can begin to use this information to evaluate how you may be impacted by the AMT at various income levels.
We can use actual tax law for 2020 and bring back our 50-year-old couple who are married filing jointly to look at the impact of gross incomes ranging from $50,000 to $1,540,000 at $5,000 increments. That allows us to chart regular and tentative minimum tax.
Below are illustrations of the actual regular and tentative tax as calculated, as well as the effective tax rate (calculated tax divided by gross income):
These charts tell us a few important things:
With our example, the effective tentative minimum tax rate is always below the effective regular tax rate. When it comes to doing financial planning around your incentive stock options, this means there’s some room to exercise and hold ISO shares and not pay anything in AMT.
You can also see there’s a greater spread between the two effective tax rates in the lower-income range than in the middle-income range. This is in large part due to the TMT exemption that reduces AMTI to $0 for lower-income earners. This means that the amount of incentive stock option bargain element you can exercise and hold without paying AMT is different at different income levels.
Once AMTI exceeds the exemption and is above $0, that value is taxed at 26%. At this point, the regular marginal tax rate is 12%. Since the marginal TMT rate 26% and marginal regular tax is 12%, the gap between the two effective rates begins to close.
The charts also show that the smallest spread between the two effective tax rates occurs at $350,000 of income. At this income level, the effective TMT is 17.80% and the effective regular tax is 18.92%.
As income increases above $350,000, the marginal TMT rate is 28% and marginal regular tax is at 32%. When the regular tax rate is higher than the TMT rate, the spread between the two effective rates gets bigger.
Finally, the percentage spread continues to grow in the AMT exemption phaseout range. The regular tax rate is 37% and the tentative minimum is a 35% “rate” (due to the exemption phaseout). Once the phaseout ends, the spread between the two again accelerates.
How to Use the Spread in Your Financial Planning for Incentive Stock Options
The spread between the regular tax and the tentative minimum tax can be useful information when strategizing on what to do with your incentive stock options. When you know the spread is not linear and that it appears differently across various gross income levels, you can understand how your decisions around ISOs impact how much in taxes you may (or may not) owe.
Using the Tax Spread to Do an AMT Crossover Calculation
The AMT crossover point is the point when your tentative minimum tax exceeds your regular tax. When this happens, you’ll likely owe AMT equal to the difference between the two.
We can use the actual tax spread between the regular minimum tax and tentative minimum tax to determine how much bargain element you can capture to make the regular tax equal the tentative minimum tax.
Again, if the two are equal, we know that no AMT will be due. That also means you’ve reached the maximum allowable exercise of bargain element in any given year.
Continuing with our couple, and a $250,000 income, we already know the regular tax and the tentative minimum tax from our calculations above. Using this, we can calculate how much bargain element can be captured to make the two equal.
The answer is $25,735.
If we add $25,735 of bargain element to the calculation for TMT, the total tax equals $42,207 — which is exactly equal to the regular tax.
Continuing our income-based chart comparing different income levels, the AMT crossover will be as follows at $50,000, $250,000 and $500,000 of gross income:
If we review chart that shows the AMT crossover at each $5,000 increment of income, we see the following:
From $50,000 to $350,000, the amount of room to exercise and hold decreases as the spread between the average tentative minimum tax and average regular tax gets smaller. At $350,000, the amount of bargain element that can be exercised and held without paying AMT is at its lowest at $13,989. Your regular tax and tentative minimum tax equal $66,207 at this point.
Past $350,000 of income, the spread continues to increase. With a gross income of $750,000, for example, the amount of bargain element that can be exercised is $113,368, for a total tax of $205,473.
Using the Spread to Calculate AMT You May Owe if You Exercise and Hold ISOs
Our example can also help us illustrate the impact of AMT when exercising incentive stock options at different income levels. Going back to our example, we can evaluate how the AMT owed changes if our couple has $50,000, $250,000, or $500,000 of adjusted gross income — but their ISO bargain element is at a constant $250,000:
In this example, we see that AMT is lowest in the low-income bracket and highest in the middle-income bracket — not the high-income bracket.
This illustrates how you may be better off exercising and holding ISO (from a tax standpoint) in years where you have a low or high income. When you have income that falls somewhere in the middle, you might actually owe more in AMT should you exercise and hold shares.
Here’s another visual representation of this how much AMT our hypothetical couple may owe based on a changing income.
As you can see, assuming this couple exercised and held $250,000 worth of the bargain element, the amount of AMT owed increases as income increases, from $50,000 to $350,000. After that point, the amount of AMT decreases until it reaches zero.
Keep in mind that your personal situation may be similar or different to the scenario above, and a personalized tax projection should be completed to see how the nuanced rules of AMT will impact your situation.
Using the Tax Spread to Plan for The AMT Credit
When you sell your previously held incentive stock option shares, you may be eligible for an AMT credit. The AMT credit essentially is you getting back your pre-payment of income tax when you exercised and held shares (the exact details of which are nuanced and may include some or all of your previously paid AMT when you sell your shares).
The AMT credit is also based on the spread between the regular tax and tentative minimum tax. The greater the spread between the two, the greater the opportunity may be to receive the credit.
Following that logic, it would make sense that having either a lower income or a higher income may allow you to capture more of the credit sooner when you sell your ISOs.
More on this topic to come in a future article. Stay tuned
What This Means for Financial Planning and Your Incentive Stock Options
From this, we can see that either a higher or a lower-income might be most advantageous when looking at your incentive stock options. Therefore, you might want to look at controlling how much taxable income your report. Doing so might help you strategically plan for the amount of AMT you owe (or get back if you are dealing with an AMT credit).
If you wish to raise your income, it may make sense to contribute to a ROTH 401(k), exercise non-qualified stock options, or do a disqualifying disposition of incentive stock options.
If you seek to lower your income, you could consider contributing to a traditional 401(k), participating in a non-qualified deferred compensation plan, or postponing the exercise of non-qualified stock options.
With good planning and the right knowledge, you can develop an exercise strategy for your equity compensation that aligns your income expectations, your incentive stock options, and your overall financial plan to create a more beneficial tax environment for you this year.
The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.