How Alternative Minimum Tax (AMT) Works

There are many (legal) tax strategies out there to minimize tax owed to the government.  For instance, say investor Derek is a BC resident and fortunate enough to have a large portfolio of dividend payers that provides his sole source of income of $70,000.  According to tax tables, Derek should be able to file his income tax and pay $0 to the government due to the dividend tax credit.

Sounds like a great deal, but the government still wants their cut, which is why the Alternative Minimum Tax (AMT) was created.  In this situation, both the AMT and the regular income tax must be calculated, with the higher of the two paid as income tax for the year.

How To Calculate AMT?

This is the basics of how to calculate AMT from the kpmg tax planning book for 2009,

  1. Calculate taxable income after all deductions for regular tax purposes.
  2. Add back the deductions not allowed under AMT – losses from tax shelters, losses from partnerships, interest expenses, employee relocation, 60% of amounts claimed under employee stock option deduction.
  3. Add 60% of the untaxed half of capital gains.
  4. Deduct gross up of dividends – only actual dividend amount is used for calculations, not the grossed up amount.
  5. Deduct $40,000 – The 2008 AMT exemption
  6. Multiply by 15% (federal tax) for 2008.
  7. Deduct Personal Credits – basic personal amount, age credit, disability, cpp contributions, EI premiums, tuition, education, medical and charitable.  Do not deduct, investment tax credits, spousal amount, tuition credit transferred from a child, dividend tax credit (and more).
  8. If the result is higher than your federal tax calculated normally, then AMT must be paid.
  9. Provincial AMT is then calculated by multiplying the above AMT amount by a provincial AMT rate (varies by province).

An Example of AMT

Going back to our BC investor Derek that made $70,000 from dividends, he would actually have to pay tax.  How much?

To calculate Derek’s income tax using regular rules, he would owe $0 in tax due to the dividend tax credit.  However, using the AMT calculations, he would owe:

  • $70,000 (dividend income) – $40,000 (amt exemption) = $30,000 x 15% = $4,500 – basic personal amount (~$1500) = $3,000 + the provincial AMT amount (up to 50% of federal amount).

Final Thoughts

In my example above, it showed an investor making $70,000 in dividends as their sole source of income.   In terms of taxation, the investor went from owing $0 in tax to at least $3,000 to the federal government (not including provincial government) due to Alternative Minimum Tax.   To put this in perspective though, assuming an average dividend of 4%, the portfolio size would be around $1.75 million so I’m sure the investor isn’t feeling too much pain.

There is a bright side though, because of the AMT exemption of $40,000 and basic personal amounts, most provinces will allow up to $50,000 in dividend income (as your only source) while paying very little tax (if any).

Disclaimer:  I’m not a tax pro, this post should be used for informational purposes only. Please consult your tax accountant if you think that alternative minimum tax applies to you.

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FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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Mayday
9 years ago

Help! We invest in a REIT and receive a monthly dividend (in addition to the lift per unit we hope to get if we ever cash in). We increased our mortgage to invest in this REIT. As per previous years, we write off part of our mortgage interest when claiming the dividend income shown on the t3. Rev Canada asked for our receipts this year. We sent all docs including our share certificate for the REIT and the mortgage docs to show interest paid. For some reason this year, Rev Canada has told us we can’t claim the interest. What can we do to convince Rev Canada that we are able to…I looked up CRA rules and it says interest paid on investments producing “income” but not capital gains is ok. Is my t3 enough?

HandyTax
11 years ago

There is a Minimum Tax Carryover which allows you to carry forward the difference between AMT and regular tax. I believe that it is 7 years, so those people who have a lot of tax shelters in only one or two years are not penalized more heavily than they should be.

Paul @ contractor tax
11 years ago

I think people will be much more careful with their money now, I can tell because there are nearly four times more blogs relating to finances after the financial crisis. Lets hope everyone learns from their mistakes!

cannon_fodder
12 years ago

Thanks, FT, for the concise article on AMT and how it is calculated. I’m creating a complex retirement spreadsheet which includes tax considerations and calculating AMT was one of those things I hadn’t got around to including.

It was only through playing around with taxtips.ca calculators (another reason why Walter Harding isn’t the best source for playing around) that I even saw AMT calculated.

I, too, was on the “give me dividends or give me death” rampage – and then the AMT caused me to rethink it. Looks like we need to move to BC for the best dividend income treatment…

Mron
12 years ago

Mike, put your mind at ease if you have a decent accountant they will find the best mix of dividends or salary to minimize your income tax. If both you and your wife own shares of your corporation (hopefully you both own separate classes) then depending on your other income your accountant should be able to determine the most beneficial amount of dividends to pay on each class of shares.

Mike
12 years ago

Yes, that’s exactly what may work. Thanks again.

Mike
12 years ago

Actually, I realized it might work out quite a bit better than I thought. My wife and i are both directors on the corporation, but she’s a stay at home mom. I played around with dividends to both of us and I was able to get the tax calculator to come out around $5000 a year. Jeez, that would be amazing if it’s accurate. I’ve printed out the report and I’ll show it to my accountant. Now if you’ve had enough of the details of my life, I’ll return you to your regularly scheduled programming. :)

Mike
12 years ago

Hehe, true enough FP. I’m seeing my accountant next week, but I just got suddenly paranoid readiing this article. I did some rough calculations using the calculator at taxtips.ca and by my math I should end up owing in the $14,000 range. We’ve been putting money aside for taxes since I started as a contractor, thankfully. We’ll see if the accountant agrees with my savings amount or if i need to increase it.