Inflation May Save You Money on Your Taxes
High inflation has taken an obvious toll on the cost of groceries, new cars and rents, among other things. But it may also help to know that, in addition to a big boost to Social Security payments, inflation could help save money on your federal tax bill next year.
That’s because the federal government annually adjusts many elements of its complex tax code, including the standard deduction and tax brackets, to reflect inflation and avoid so-called stealth tax increases.
The adjustments also mean you can contribute more next year to retirement savings and other accounts that offer tax breaks, like health savings accounts.
Over the past 10 years, inflation was modest, so annual tweaks were small, said Kyle Pomerleau, a senior fellow at the American Enterprise Institute, a center-right think tank. But this year, inflation hit a 40-year high. So the upward adjustments to various tax provisions for 2023 are expected to be significant — about 7 percent, more than double the 3 percent in 2022, according to projections by Mr. Pomerleau and others.
This year, the middle federal tax rate of 24 percent applied to ordinary income up to $89,075 for a single filer and up to $178,150 for a couple filing jointly. Next year, the upper income thresholds for that bracket are projected to increase to about $95,375 for single taxpayers and $190,750 for couples. (The Internal Revenue Service usually announces official numbers in late fall.)
What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
What causes inflation? It can be the result of rising consumer demand. But inflation can also rise and fall based on developments that have little to do with economic conditions, such as limited oil production and supply chain problems.
Is inflation bad? It depends on the circumstances. Fast price increases spell trouble, but moderate price gains can lead to higher wages and job growth.
How does inflation affect the poor? Inflation can be especially hard to shoulder for poor households because they spend a bigger chunk of their budgets on necessities like food, housing and gas.
Can inflation affect the stock market? Rapid inflation typically spells trouble for stocks. Financial assets in general have historically fared badly during inflation booms, while tangible assets like houses have held their value better.
A quick review: The federal government uses a progressive, or graduated, income tax system. Marginal tax rates ranging from 10 percent to 37 percent are applied to income in seven ranges, or brackets. The portion of your income falling into each bracket is taxed at the applicable rate. The average, known as your “effective” tax rate, is lower than your top marginal rate.
If the bracket boundaries weren’t periodically adjusted for inflation, more of your income would move into a higher bracket, increasing your tax bill — even if your real income hadn’t kept pace with the cost of living. Tax nerds call this “bracket creep.”
“It can push your tax bill up even if you don’t feel like you have higher income,” said Kim Rueben, a fellow at the Tax Policy Center.
Taxpayers whose income was near the upper edge of a bracket might see some or all their income pushed into the next, higher bracket if the thresholds weren’t updated, said Edward Karl, vice president of taxation with the American Institute of Certified Public Accountants.
“If it wasn’t adjusted, they would say, ‘What the heck happened on my tax return?’” he said. “That’s a big tax increase.”
To avoid bracket creep, the government began adjusting, or indexing, tax brackets for inflation in the early 1980s, after a long period of raging inflation.
Daniel T. Massey, a principal with Walz Group, an accounting firm in Lititz, Pa., said people whose income had kept pace with inflation would see no change in their tax bracket, while someone with a stagnant or fixed income might have a lower tax bill because of the inflation adjustments.
Mr. Massey gave this example: A single filer in 2021 who earned $100,000 and took the standard deduction would have paid $15,009 in taxes, for an effective tax rate of 15 percent. Under projected brackets for 2023, a taxpayer with the same income would pay $14,383 — a saving of $626 — for an effective rate of 14.4 percent.
The standard deduction, which reduces your taxable income without requiring that you itemize deductions, is expected to rise to $13,850 next year from $12,950 this year for single filers and to $27,700 from $25,900 for couples.
Here are some questions and answers about income tax inflation adjustments:
How will inflation adjustments affect retirement and health account contributions?
Next year, you’ll be able to contribute an estimated $6,500 to an individual retirement account, up from $6,000 this year. Limits are $1,000 higher if you’re over 50; this “catch-up” amount is not indexed to inflation, but would be under legislation pending in Congress known as Secure Act 2.0. (Adjustments for workplace 401(k) accounts are calculated differently, based on data that will become available next month, Mr. Pomerleau said).
The maximum contribution to a flexible health spending account is projected to increase to $3,050, from $2,850 this year.
And if you have a health savings account, a tax-favored account available with high-deductible health insurance plans, you’ll be able to contribute $3,850 as an individual and $7,750 for family coverage, up from $3,650 and $7,300 this year, according to limits confirmed by the I.R.S. (Catch-up contributions of $1,000, for people over 55, are not adjusted for inflation.)
Do states adjust their income tax provisions for inflation?
Many states have progressive income tax systems like the federal government. But unlike the federal government, some of those states, including New York, New Jersey and Connecticut, don’t index for inflation, Ms. Rueben said. Recently, however, there has been more interest in indexing. New Jersey, for instance, is considering adopting inflation adjustments.
“Bracket creep is an unlegislated tax increase,” said Jared Walczak, vice president of state projects with the Tax Foundation, a right-leaning think tank. If lawmakers want to raise taxes, he said, “they should have to vote on it.”
Are there income tax provisions that aren’t adjusted for inflation?
Yes. For example, the income threshold for paying the 3.8 percent net investment income tax, also known as the Medicare tax, is fixed at $200,000 for individuals and $250,000 for joint filers.