Three letters, AMT, are striking tax fear in the hearts of more and more middle-class filers.

These folks are simply trying to use the tax code, legally, to lower their annual Internal Revenue Service bills. They claim exemptions for eligible dependents, deduct the interest on their mortgage and associated equity loan, and write off the state income taxes they pay. Some of these tax breaks, however, will do them no good under the alternative minimum tax system.

Commonly referred to as the AMT, this tax has its own set of rates (26% and 28%) and requires a separate computation that could substantially boost your tax bill. Basically, it's the difference between your regular tax bill, figured using ordinary income tax rates, and your AMT bill, figured by filling out more IRS paperwork. When there's a difference, you must pay that amount, the AMT, in addition to your regular tax.

The AMT was designed in 1969 to ensure that wealthy taxpayers didn't use loopholes to escape paying their fair share of taxes. The original target was 155 filers with the then-exorbitant income of $200,000 who avoided paying any federal taxes.

More AMT Victims, Higher Taxes

On today's tax returns, when an AMT payment is required, affected taxpayers could end up paying thousands more in taxes. Absent any law change, by 2015, some estimates predict that nearly 50 million filers could end up paying this parallel levy.

Why the increase? Because the tax is not indexed for inflation. Without that annual adjustment, your yearly raises of a few percentage points have been moving you closer or even into the income realm that the tax law deemed almost 40 years ago as prime AMT bait.

You could owe AMT if your taxable income in 2010 was more than:
  • $72,450 for a married couple filing a joint return and surviving spouses.
  • $47,450 for singles and heads of household.
  • $36,225 for a married person filing separately.

Congress regularly bumps up the earnings amounts to keep more middle-income filers from paying more under the system. While that law change helps out millions of taxpayers who might otherwise pay the AMT, the uncertainty of when and how much relief will be provided is a constant area of frustration for taxpayers who have encountered or might face the alternative minimum tax.

There is general agreement, from the Taxpayer Advocate Service and blue ribbon presidential panel members to representatives and senators, that something must be done to fix the AMT problem once and for all.

But each year, lawmakers and economists wrangle over the best way to deal with the AMT. Many want to scrap the tax altogether. But because it does bring in more money to the Treasury, others simply want to modify it a bit.

Meanwhile, taxpayers are left to deal with the AMT. Here's what to look for, as well as what to look out for, when it comes to this potential added tax burden.

Calculation Insult to Tax Injury

Adding insult to injury, the AMT's parallel system demands that taxpayers do more work to pay more in taxes. The effort is required in filing paperwork (the dense, two-page Form 6251, Alternative Minimum Tax -- Individuals) and maintenance of separate records for regular and alternative tax purposes.

Even filers who escape actual payment of the higher tax still must do additional work just to learn that they are off the AMT hook.

To help sort through the AMT mess, some taxpayers turn to computer software packages, most of which include AMT computation, or hire professional help. Both choices should help you stay on the IRS' good side, especially if you owe AMT, or at least put your mind at ease if you don't.

But the options also will add to the overall cost of calculating your tax bill.

Free Help in Figuring Your AMT

For the last couple of years, the IRS has provided some free AMT calculation assistance.

AMT Assistant is an online tool to help taxpayers determine whether they owe the tax. You just answer a few questions about entries on your draft 1040 and the system does the rest. Based on your entries, the calculator will tell you that either you do not owe the AMT or that you must go further and complete more computations to find out if you owe the AMT.

The AMT Assistant is especially welcome to filers who still do their taxes by hand, because the automated program essentially replaces the tedious work sheet taxpayers are instructed to use to determine if they fall under the AMT.

With the online program, says the IRS, most people will spend only about 10 minutes to find out their AMT fates.

There are a few special instances where a filer will need to take a few extra online steps, such as claiming the foreign tax credit, dealing with disaster-related tax issues or preparing a return for a child. But most taxpayers will need just Form 1040, completed through line 44, (that's the tax you owe under the regular system), and Schedule A if itemizing.

You don't have to enter your name, Social Security number or other identifying data. The program, which guides you through a series of question-and-answer pages, only wants the numerical data from your forms.

When you're finished, it will tell you whether you now have to fill out the AMT form, but it won't tell you the actual tax damage. You'll still have to fill out Form 6251 to find out that amount.

AMT Starting Point

How do you know, without using tax software or the AMT Assistant, if you might be caught in the AMT net? There are some indicators, but it's not always easy to tell.

The starting point for figuring any AMT is your regular taxable income. This is the stage where the AMT Assistant (or work sheet, if you still insist on doing things by hand) kicks in.

Basically, some of the deductions you claimed to figure your regular tax bill must be added back. These are known as tax-preference items. You also might find a special exemption amount is subtracted. The resulting amount is subject to the alternative tax.

Many of the tax breaks not allowed under the AMT system do affect predominantly wealthy individuals or businesses with complicated tax circumstances. These include incentive stock options, intangible drilling costs, tax-exempt interest from certain private activity bonds, and depletion and accelerated depreciation on certain leased personal or real property.

Common Tax Breaks Disallowed

The AMT also rejects or reduces many common tax breaks used every year by individual taxpayers to lower their IRS bills.

For example, under the AMT, you cannot deduct state and local taxes. This is a major blow to many filers, because most states collect income taxes and all jurisdictions have some type of levy that generally can be counted against a federal tax bill.

Medical costs are still allowed, but the AMT requires they exceed at least 10% of your adjusted gross income rather than the 7.5% threshold of the regular tax system. Miscellaneous itemized deductions, although limited under the regular tax system, are disallowed under the AMT. Even large families can be hit. If your personal exemption total is big, look out.

Own a home? Some cherished home-related tax breaks take an AMT hit. While mortgage interest on your main and second home is still AMT-deductible, home equity loan interest is restricted. It can't be deducted unless the money is used solely to pay for home improvements. Your home's property taxes also are disallowed as deductions under the AMT.

Other commonly claimed credits also technically affect AMT calculations, such as those for dependent care and education costs. However, for the last few years the congressional AMT patch has allowed AMT taxpayers to continue to count these in their calculations.

Once you add back these AMT disallowances and run the numbers, you might be subject to a bigger IRS bill if your taxable income exceeds the annual exemption amount for your filing status. 

And what about those high-income taxpayers the AMT was created to catch? The legislative irony is that today's alternative tax usually doesn't affect them. They tend to owe more under the regular tax system because the two top ordinary tax brackets