Inflation Has Tax Impacts, Too
Inflation has been making every area of our lives more expensive as the costs of the goods and services we use every day have skyrocketed. The Federal Reserve is attempting to lower inflation by using the bluntest tool in its arsenal – raising the key short-term interest rate.
This has meant that as prices have continued to increase, they are being followed by higher costs for debt. If you’re carrying a credit card balance, you’ve likely noticed the difference. And hopefully, you have a fixed-rate mortgage.
But there may be a small silver lining. The IRS pegs tax brackets, tax deductions, 401(k), and other tax-efficient vehicle contribution amounts to inflation. A careful review of your financial picture, combined with some proactive tax planning, may save you money and set you up for increased savings growth in the years to come.
Tax Brackets Are Moving North
Tax brackets are increased due to inflation to ensure that tax brackets reflect people’s real income. Inflation means credits, deductions, and exemptions are worth less, which translates to an increase in taxes paid. Raising the amount of the income range in each bracket shelters more income from higher rates.
The amount of the increase is usually so small that it doesn’t affect most people’s tax brackets, but this year the brackets jumped a lot.
- 10%: $1-11,000 for singles and $0-$22,000 for couples
- 12%: $11,001-$44,725 for singles and $22,001-$89,450 for couples
- 22%: $44,726-$95,375 for singles and $89,451-$190,750 for couples
- 24%: $95,376- $182,100 for singles and at $190,751-$364,200 for couples
- 32%: $182,101-$231,250 for singles, and $364,201- $462,500 for couples
The Standard Deduction Is Increasing
Filing your taxes may also have gotten simpler. The standard deduction – the amount you are entitled to claim without itemizing – increased to $13,850 for single files in 2023. For married couples filing jointly, the new deduction amount is $27,700. If you don’t usually itemize, this is probably good news. However, if you do itemize, you may find that some of your regular deductions, such as gifts to charity, are no longer tax benefits.
One solution is to bunch your charitable gifts. “Bunching” refers to grouping donations intended for several years into a single year. This strategy is only effective if all your itemized deductions, including the bunched gifts, are more than the standard deduction.
Retirement and Healthcare Savings Contributions
Retirement savings contributions are getting a boost of almost 10% in 2023. The new maximum contribution limit is $22,500. The “catch-up” limit for people over 50 also increased to $7,500. The new limits don’t just mean increased savings; they also lower your taxable income.
Flexible health spending accounts got a $200 boost, allowing you to contribute $3,050 of pre-tax dollars to this type of account to pay for medical costs that aren’t covered by insurance.
Health Savings Accounts (HSAs) have new maximum contributions, too. An individual can contribute up to $3,850, and the family contribution has risen to $7,750. These accounts are referred to as “triple-tax-advantaged” because you contribute pre-tax dollars that lower your taxable income in the year you contribute, the accounts grow tax-free, and qualified withdrawals are also not taxed.
It’s Not All Good News
Social security benefits increased as well, which may be good news for retirees. However, if you’re still working, you’re still paying into the system. Social security taxes are 6.2% of income, up to a maximum earnings ceiling. The limit increased by almost 9%, to $160,200 in 2023, from $147,000. This translates to a dollar amount of $9,932, up from $9,114 in 2022.
The Bottom Line
Elevated inflation is likely to be with us for a while longer. The Fed is working to dampen the economy to bring prices down, but a robust labor market and ongoing – although lessening – supply chain issues are pushing the other way. Taking advantage of the silver lining of inflation by maximizing tax-advantaged savings, and undertaking proactive tax-planning strategies, can help you keep your financial planning on track.
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