529 Plans and AMT

Many two-income Oregon families end up owing AMT due to our two-legged tax “stool.” That’s because, absent sales tax, we pay higher income and property taxes. For most non-1%-ers who end up owing AMT, state taxes are the biggest add-back item in the AMT calculation.* That means that if you’re paying AMT, a 529 plan contribution can be doubly beneficial.

Without AMT, your state taxes are deductible against your federal income. So when you reduce your state income taxes, you also increase your federal income taxes. Let’s say you’re in the 25% federal tax bracket and you made the full deductible (Oregon) 529 contribution in 2014, $4530 (married filing joint). Your state taxes would decrease by $407.70 (9% of $407.70.) That, in turn, reduces your federal deductions by $407.70, meaning you’d pay an extra $101.93 in federal income taxes for a net tax benefit of $305.77.

With AMT, your state taxes are one of several items added back to your calculated taxable income. Then that figure, net of your Exemption Amount, is taxed at 26% or 28%. So decreasing your state income taxes decreases your AMT add-back items which decreases your federal AMT tax.

Note that AMT, like all federal tax calculations, calculates based on the amount of state tax paid during the year, not tax due. To maximize the tax benefit of a 529 plan contribution, you’ll want to adjust your withholding to account for the tax deduction.

*Refresher course: The AMT, or alternative minimum tax, computes some tax items differently and taxes at a flat rate, rather than the progressive rate of regular tax tables. Some tax deductions that are allowed in the normal tax calculation, including state taxes, are added back in the AMT calculation and therefore are not deductible against federal income.

See How Much to Save for additional insights.