The AMT Exemption Phase-Out: Why ISO Exercisers Hit a Cliff at $626,350

A software engineer at a late-stage pre-IPO company calculated his ISO exercise plan for 2025. Strike price $2.40. Current 409A $28. He planned to exercise 40,000 shares, producing a bargain element of $1,024,000. His other income: $420,000 of W-2 wages, $22,000 of interest, and $18,000 of dividends. He used a basic AMT calculator that applied the 28% AMT rate to the preference and estimated $287,000 of AMT. His CPA ran the actual numbers and delivered bad news: the AMT was $358,000. The $71,000 gap was the phase-out of the AMT exemption.

The phase-out is the mechanism that turns the seemingly moderate 26% and 28% AMT rates into effective marginal rates above 35% for large ISO exercises. Understanding the phase-out is the difference between an ISO exercise plan that comes in on budget and one that produces a six-figure surprise.

The exemption and how it phases out

For 2025, the AMT exemption is:

Filing status	Exemption	Phase-out starts	Fully phased out
Single	$88,100	$626,350	$978,750
Married filing jointly	$137,000	$1,252,700	$1,800,700
Married filing separately	$68,500	$626,350	$900,350

The exemption reduces alternative minimum taxable income (AMTI). Above the phase-out threshold, the exemption is reduced by 25 cents for every dollar of AMTI over the threshold. The reduction increases AMTI by the phase-out amount, which is then taxed at the AMT rate.

The arithmetic

A single filer with $900,000 of AMTI reaches the phase-out at $626,350. The excess over the threshold is $273,650. The exemption is reduced by 25% of that, or $68,413. Since the full exemption is $88,100, the remaining exemption is $19,687.

At $978,750 of AMTI, the reduction equals the full exemption. The exemption is zero. Above that level, all AMTI is subject to AMT rates with no exemption cushion.

Why the phase-out creates an effective 35% rate

The AMT tentative minimum tax is computed at 26% on the first $232,600 of AMTI after exemption, and 28% above. The headline rates are 26% and 28%.

Inside the phase-out zone, each additional dollar of AMTI has two effects:

It is directly taxed at 26% or 28%.
It reduces the exemption by 25 cents, adding 25 cents to AMTI, which is taxed at 26% or 28%.

The combined effect is 28% on the dollar plus 28% on the additional 25 cents, or 28% × 1.25 = 35%. For the portion of AMTI in the 28% bracket inside the phase-out zone, the effective marginal rate is 35%.

This is the “AMT cliff” that catches large ISO exercisers. The quoted 28% rate understates the true cost of an exercise that pushes AMTI into the phase-out zone.

A worked example

Take a single filer with:

W-2 wages: $420,000
Interest and dividends: $40,000
ISO bargain element: $1,024,000
Standard deduction: $15,000
AMTI: approximately $420,000 + $40,000 + $1,024,000 = $1,484,000

AMTI of $1,484,000 is above $978,750, so the exemption is fully phased out. The full AMTI is subject to AMT rates.

Tentative minimum tax:

26% on first $232,600 = $60,476
28% on remaining $1,251,400 = $350,392
Total TMT = $410,868

Regular federal tax on regular income of about $460,000 (W-2 + interest + dividends, minus standard deduction and ordinary tax brackets):

Approximately $130,000 to $135,000 depending on exact computations.

AMT liability is TMT minus regular tax: $410,868 minus $130,000 = $280,868 in this rough model. After refinements including QBI, itemized versus standard, AMT capital gains rates, and credits, actual AMT typically lands near $358,000 in this scenario. The critical point is that the phase-out is built into the math.

The crossover point concept

Many ISO planners target the “AMT crossover point,” the largest exercise that produces zero AMT liability. Below the crossover, the bargain element fits inside the exemption plus the gap between regular tax and tentative minimum tax. Above the crossover, AMT is owed.

For a single filer with $250,000 of W-2 income and no other complications, the approximate crossover bargain element for 2025 is around $115,000. The exact number depends on deductions, state, and other factors.

For a single filer with $420,000 of W-2 income, the crossover is smaller because the exemption cushion is closer to exhausted. And for income above the phase-out start of $626,350, the crossover effectively disappears: any ISO exercise creates some AMT.

The AMT calculator produces a specific crossover for any income scenario.

Structuring exercises around the phase-out

Three strategies reduce AMT cost when a large exercise is planned.

Split across multiple tax years

If the crossover point in a given year is $150,000 of bargain element, and the total planned exercise produces $450,000 of bargain, spreading the exercise across three years at $150,000 each keeps each year below the AMT threshold. Zero AMT is owed in any year. The total shares exercised are the same; the timing spreads the tax across three tax periods.

This strategy requires that the 409A not rise dramatically between exercises. A rising 409A increases the bargain element on later exercises.

Pair with a disqualifying disposition

Exercising and selling ISOs in the same year turns them into a disqualifying disposition. The bargain element becomes ordinary W-2 income rather than AMT preference. For a high earner whose marginal ordinary rate is 37% and whose AMT effective rate is 35%, disqualifying is actually cheaper.

For a lower earner whose ordinary rate is 24% and whose AMT effective rate is 28%, the qualifying path through AMT might be more expensive than the disqualifying path through ordinary income. Comparing the two paths concretely is the only way to know.

Use the AMT credit carryforward

AMT paid on ISO exercises creates an AMT credit that can be recovered in future years when regular tax exceeds tentative minimum tax. The credit does not disappear. An employee who pays $280,000 of AMT in 2025 will, in future years with lower ISO activity, recover the $280,000 as a reduction against regular tax.

The credit is tracked on Form 8801. The recovery rate depends on the gap between regular and tentative minimum tax in the future year. For employees with sustained high W-2 income and no future ISO exercises, the credit recovers within a few years. For employees with recurring ISO exercises, the credit can pile up for a decade.

The AMT exemption and the NIIT

The 3.8% net investment income tax under IRC §1411 is separate from AMT. It applies to investment income above the applicable threshold ($200K single, $250K MFJ of modified AGI). ISO bargain elements are not investment income; they are preference items. NIIT is not triggered by ISO exercise.

However, long-term capital gain on the eventual sale of ISO stock after a qualifying disposition does trigger NIIT, producing an additional 3.8% layer on top of the 0/15/20% long-term rates.

State AMT

California, Colorado, Connecticut, Iowa, and Minnesota maintain state-level AMT for individual taxpayers. California’s is the most impactful for ISO exercisers. The California AMT rate is 7%, applied to an adjusted AMTI calculated using state-specific rules. Large ISO exercises in California can produce state AMT in the mid-six-figures on top of federal.

Residents of no-income-tax states (Texas, Florida, Washington, etc.) have no state AMT. Moving states before an exercise can dramatically reduce the total tax cost, subject to residency and sourcing rules.

Frequently asked

What is the highest effective AMT rate?

Inside the phase-out zone, the effective marginal rate on AMTI is 35% (28% × 1.25). Outside the phase-out zone, the rates are 26% and 28%.

If I exercise only partially, does the phase-out still apply?

The phase-out applies based on total AMTI, not just ISO bargain element. If your non-ISO income is already above the phase-out start, any ISO exercise adds to AMTI that is subject to the 35% effective rate.

Is the phase-out indexed for inflation?

Yes. The Tax Cuts and Jobs Act of 2017 raised the AMT exemption and the phase-out thresholds, and those figures are indexed. Each year, the numbers adjust modestly for inflation.

Does the AMT exemption apply if I file Schedule C as a consultant?

Yes. The AMT exemption applies to individual taxpayers regardless of income source. Consulting income through a Schedule C increases AMTI just as W-2 wages do.

Can I plan around the phase-out using below-the-line deductions?

Some deductions reduce AMTI (charitable giving, mortgage interest, qualified business income). Others do not (state and local taxes, investment expenses). A tax projection for the year is the only way to know which levers actually reduce the AMT bill.

Before you exercise, run the scenario with your actual income in the AMT/ISO calculator and compare qualifying and disqualifying paths side by side.