High Inflation Brings Changes To Your Tax Bill

A side effect of high inflation affecting Americans’ purchasing power could be lower tax bills.

Many workers will receive larger paychecks and have more money to invest in their retirement accounts in January when the Internal Revenue Service makes its annual inflation adjustments to dozens of tax provisions. Typically, these are minimal changes, but given the persistently high inflation data in August, tax experts are estimating a significant impact on taxes for 2023.

More Americans’ incomes will be taxed at lower rates next year when thresholds for income tax brackets and the standard withholding are raised thanks to automatic inflation adjustments built into the tax code, tax experts say. According to Northern Illinois University accounting professor Jim Young, a single taxpayer with an adjusted gross income of $100,000 in 2023 could see a tax savings of about $500 compared to someone with the same income this year.

Inheritance and gift tax thresholds are also expected to rise, giving a couple nearly $2 million more protection from those taxes. And retirement contribution limits are likely to be raised, meaning more tax-deferred saving.

“Over the past decade, inflation has been moderate, so we’ve only seen small increases in tax parameters each year,” said Kyle Pomerleau, federal tax policy expert at the American Enterprise Institute. “This year we’re going to see a much larger adjustment as prices have increased at a much faster rate.”

These inflation adjustments can hardly be called a silver lining as Americans pay more for everything from housing to food to energy.

The IRS makes the adjustments based on formulas established in federal law, which are slightly different from headline inflation figures. The Labor Department said on Tuesday that its consumer price index in August was up 8.3% from the same month a year ago.

The tax provision adjustments are tied to an alternative measure of inflation called the chained consumer price index, which accounts for the substitutions buyers make as costs rise. The average of chained CPI from September 2021 to August 2022 will be used to calculate the 2023 adjustments that the IRS will announce in October or November. These ultimately affect tax returns for tax year 2023, which are filed in early 2024.

“Adjusting tax return dates for inflation was a deliberate move by Congress to protect taxpayers from annual inflation,” Mr. Young said. “Hopefully this will help taxpayers deal with rising prices.” The benefits of these changes could be offset by inflation in other ways. If your wages have gone up, your overall tax bill may not go down, Mr. Young said.

As inflation rises in the US, rising food and energy costs have pushed the nation’s most popular price index to its highest level in four decades. The WSJ’s Gwynn Guilford explains how the CPI works and what it can tell you about inflation. Image: Jacob Reynolds

Here are the estimates for the IRS adjustments, according to the American Enterprise Institute:

The threshold for the top federal income tax bracket in 2023 for married couples is expected to increase by nearly $50,000 next year, and that 37% rate applies to incomes above $693,750. For individuals, this upper tax bracket starts at $578,125.

Those levels and the other tax bracket breakpoints will all rise by about 7% beginning in tax year 2022, compared to about 3% last year, which was the largest increase in four years. This year’s increase is the largest in the past 35 years, Mr Young said.

According to the 2022 Social Security Administrators report, the Social Security payroll tax level is expected to increase 5.5% in 2023, from $147,000 to $155,100.

The standard deduction for married couples is expected to be $27,700 for 2023, up from $25,900 this year, and $13,850 for single people, up from $12,950. This is the amount that those who do not report deductions on their returns can deduct from their total taxable income.

The federal estate tax cut-off amount that an individual can protect from estate tax this year is $12.06 million. That’s expected to rise to $12.92 million in 2023, meaning a couple with little planning could save nearly $26 million from estate taxes.

The annual tax-free gift limit is expected to increase from $16,000 this year to $17,000 in 2023. The taxpayers who will benefit are high net worth individuals, Mr Young said. You can give more without inheritance or gift tax consequences.

The maximum contribution amount for an individual retirement account is expected to increase to $6,500 for 2023, up from $6,000 where it has been stuck since 2019. The maximum allowable contribution for a healthcare flexible spending account is expected to increase to $3,050 in 2023 from $2,850 this year.

The maximum contribution amount for a 401(k) or similar retirement plan is governed by another formula using inflation data through September. Actuaries at Milliman, a benefits company, estimate that the contribution limit will increase from $20,500 this year to $22,500 in 2023 and the catch-up amount for workers over 50 will increase from $6,500 to at least $7,500.

It is even more complicated with the child tax credit. Under current law, the total tax credit of $2,000 per child is not adjusted for inflation, Mr Pomerleau said. But the additional child tax credit, which is refundable and also available to non-taxpayers, is adjusted for inflation. It is expected to surge from $1,500 to $1,600 in 2023. The income limits associated with the CTC are not adjusted for inflation.

Write to Ashlea Ebeling at [email protected]