Always Avoid the Alternative Minimum Tax: Financial Advice to Break Part 3

Avoiding the alternative minimum tax (AMT) is usually top-of-mind for individuals who receive valuable stock options from their employers. This is especially true when those individuals own substantial amounts of company stock. This was the case for a client of mine who accumulated a large amount of company-incentive stock options. Dora, not her actual name, (all client interactions are confidential) decided it was time to find another job.

Under typical circumstances, we would have been proactive and developed a long-term strategic tax plan to minimize the sting of the AMT. When you plan ahead you can minimize the taxes you will owe on these valuable incentive stock options. But because Dora wanted to change employers, she had to act fast to meet tight deadlines and faced some big tax bills.

Bad Alternative Minimum Tax Advice from a 1-800 Number

She called the financial firm which held the incentive stock options and asked, “What do I need to do to avoid the AMT if I exercise all my incentive stock options?” The helpful person at the other end of the 1-800 number was not allowed to give advice but was able to answer her questions. Here are the three options she was given.

• Let the stock options lapse and owe nothing in taxes. Not owing taxes may sound good but it means you receive nothing for all of your hard-earned incentive stock options.

• Exercise all of the options now and then sell them immediately. This will avoid the AMT. If you think this sounds too easy and too good to be true, you are correct. The below information explains why this is a terrible idea.

• Exercise all of the options but do not sell them for a year. This option will lead to the AMT. While this may sound like a bad idea, it could be the opposite.

Can you Lower your Tax Bill by Getting Hit with the AMT?

Generally, avoiding the alternative minimum tax will save you money. The AMT is either 26% or 28% depending on your total income. It was implemented in the 1960s to ensure wealthy people paid some taxes. It has not been indexed for inflation so it now often ensnares the merely successful.

In Dora’s case, we are talking about exercising millions of dollars of company stock options. If we chose option two, she would have avoided the AMT but all the money would instead be recognized as regular income. That would have placed much of her income at the top federal tax rate of 37%. That rate, coupled with the fact that she lives in California with one of the highest state income taxes in the nation at 13.3%, was not the best decision. Dora would have ended up paying several hundred thousand dollars more in taxes.

When millions of dollars in company incentive stock options are exercised, the tax bill will be unavoidably large. We wanted to be strategic and plan for her to pay the least amount of taxes possible based on these options. It was determined that paying the AMT (option three), resulted in a lower tax bill that was several hundred thousand dollars less than option two. Today, Dora will never have to work again if she chooses not to. Financial independence has been achieved.

Best AMT Advice:

The purpose of this example is to show that the financial advice that has treated you well for years may not be relevant to your current circumstances. Before making huge financial decisions check the numbers. Also, it is important to remember that financial firm call center representatives are unable to give expert financial advice.

Sometimes great information does not always translate into valuable financial advice. When the numbers get big, work with your financial team, a CFP and CPA, to create a strategic financial plan that will keep you on track for your various financial goals.

Live for Today, Plan for a Richer Tomorrow.

DAVID RAE, CFP®, AIF® is a Los Angeles- retirement planning specialist with DRM Wealth Management. He has been helping people reach their financial goals for over a decade. He is a contributor to Forbes.com. Has also written for the Advocate, Investopedia and Huffington Post.  Follow him on Twitter @davidraecfp on Facebook or   www.davidraefp.com.

If you liked the Alternative Minimum Tax post you may also like this other tips to avoid bad financial advice:

Earning Less to Pay Less Taxes? Financial Advice to Break Part 1

The More ROTH IRA the Better: Financial Advice to Break Part 2