Taxes are a fact of life, but few people take the time to understand how economic conditions can affect what they owe. Inflation is one of those economic factors that can have a surprising impact on your tax filing and may even decrease the amount you owe.
In this article, we’ll explore how inflation impacts your taxes to help with your tax planning and potentially even save you money when it’s time to file your federal income tax return.
How inflation impacts tax brackets
Inflation refers to the rate at which the general level of prices for goods and services is increasing. It’s a measure of the decrease in the purchasing power of a dollar (or any other unit of currency) over time. While some inflation is expected, record-high inflation in 2022 was particularly painful for consumers because it made everyday purchases like gas and groceries more expensive while reducing the value of their savings and wages.
However, when it comes to taxes, inflation can have some surprising impacts. In particular, it can help reduce the amount of tax you owe.
While the tax rates generally don’t change from year to year—at least not without lawmakers enacting tax reform legislation—the federal income tax brackets tied to those rates are adjusted for inflation on an annual basis.
For example, for 2022 returns, the income threshold for the 32% tax bracket was $170,050 to $215,950 for single filers. However, for 2023 returns, that income threshold increased to $182,100 to $231,250. So if you had $180,000 of taxable income, you would be in the 32% tax bracket in 2022 but drop into the 24% tax bracket in 2023. In other words, you might feel like you received a bit of a tax break even though your taxable income stayed the same from year to year.
Tax Deductions, tax credits, and inflation
Aside from tax brackets, inflation can also impact tax deductions and tax credits. Tax deductions are expenses subtracted from your overall income to reduce taxable income. Tax credits, on the other hand, are dollar-for-dollar reductions in your tax liability.
Many deductions and credits are adjusted annually for inflation. As a result, the deduction or credit amount changes, or the IRS adjusts the income limitations that apply to those tax breaks.
Let’s look at some common deductions and credits and how they were adjusted for inflation from 2022 to 2023.
The standard deduction allows taxpayers to reduce their taxable income by a fixed amount without having to itemize deductions. Nearly 90% of taxpayers claim the standard deduction.
For the 2022 tax year, the standard deduction was:
- $12,950 for single filers
- $25,900 for married couples filing jointly
- $19,400 for heads of household
In 2023, those amounts took a relatively large leap thanks to inflation:
- $13,850 for single filers
- $27,700 for married couples filing jointly
- $20,800 for heads of household
This means taxpayers who claim the standard deduction will be able to reduce their taxable income by a higher amount in 2023 compared to 2022.
It’s worth noting that taxpayers 65 or older or blind are eligible for an additional standard deduction amount. For the 2022 tax year, the additional amount was $1,350 for single filers and $1,100 per spouse for married couples filing jointly. In 2023, those amounts increased slightly to $1,375 for single filers and $1,125 per spouse for married couples filing jointly.
Overall, the adjustments to the standard deduction for inflation may seem small, but they can add up and provide some relief for taxpayers. Keeping track of these changes and adjusting your tax planning accordingly is essential to maximize potential savings.
Earned income tax credit
The Earned Income Tax Credit (EITC) is a refundable tax credit that benefits low- to moderate-income workers and families. The amount of the credit is based on an individual’s earned income, as well as their filing status and number of qualifying children.
In 2022, the maximum EITC amount for taxpayers with three or more qualifying children was $6,935. In 2023, the maximum tax credit increased to $7,430.
The income limits for claiming the EITC increased for inflation as well. In 2022, single taxpayers with three or more children had to earn $53,057 or less ($59,187 or less for married taxpayers filing jointly). In 2023, the income limit increased to $56,838 for single filers and $63,698 for married filing jointly.
These adjustments mean more taxpayers may be eligible for the EITC in 2023, and those who are eligible may receive a larger credit.
Inflation affects not only the value of money and tax brackets but can also impact how much you can contribute to a retirement plan. Retirement plans, such as an Individual Retirement Account (IRA) or 401(k), have annual contribution limits (and sometimes income limits) set by the federal government. These limits are designed to ensure that tax-advantaged retirement savings are not abused by the wealthy.
Inflation can be a double-edged sword if you want to contribute the maximum amount to your retirement plan. On the one hand, the IRS adjusts annual contribution limits for inflation.
Here are the annual contribution limits for several common retirement accounts.
|Account Type||2022 Contribution Limit||2023 Contribution Limit|
On the other hand, inflation can also impact your ability to afford to contribute to your retirement accounts. For example, if inflation is high but you aren’t earning more, you may struggle to cover basic living expenses like food, housing, medications and transportation. In that case, maxing out your retirement account contributions might be difficult.
Health savings accounts
A Health Savings Account (HSA) is a tax-advantaged savings account that allows individuals with high deductible health plans (HDHPs) to save for qualified medical expenses. They also offer some tax advantages. Contributions to an HSA are tax-deductible, investment earnings in the account grow tax-free, and the funds withdrawn for qualified medical expenses are tax-free.
As with other tax-advantaged savings accounts, HSA contribution limits are set by the federal government and are subject to change each year due to inflation.
For 2022, the contribution limit for an individual with self-only coverage was $3,650, while the limit for those with family coverage was $7,300. However, in 2023, these limits increased to $3,850 for self-only coverage and $7,750 for family coverage.
Inflation also significantly impacts Social Security, which provides a safety net for retired and disabled individuals.
Social security benefits are initially calculated based on the average wages a worker earned during their 35 highest-earning years. However, these benefits are adjusted annually to account for inflation.
From 2022 to 2023, the cost-of-living adjustment for Social Security benefits and Supplemental Social Security Income (SSI) increased payments by 8.7%.
Not retired yet? Then you may pay more payroll or self-employment taxes to help fund Social Security. That’s because there is a limit on the amount of your earnings subject to Social Security taxes, which is adjusted for inflation each year.
For 2022, the first $147,000 of your earnings were subject to Social Security taxes (or the Social Security portion of self-employment taxes). In 2023, $160,200 of your earnings are subject to Social Security.
Estate and gift taxes
Inflation also affects the amount you can gift to others without filing a gift tax return or owing any gift tax. The annual gift tax exclusion is the amount of money or property you can give another person without reporting it to the federal government. The exclusion amount is adjusted annually to keep pace with inflation.
In 2022, the annual gift tax exclusion was $16,000 per recipient, meaning you could give up to $16,000 to as many people as you wanted without filing a gift tax return. In 2023, the annual gift tax exclusion increased to $17,000 per recipient.
However, it is essential to note that the annual gift tax exclusion is just one part of the gift tax system. If you give more than the annual exclusion amount to a single recipient in a year, you don’t have to pay gift taxes on the excess amount unless you’ve exceeded your lifetime exemption.
The lifetime exemption is the amount of money or property you can pass on to your heirs without paying federal estate taxes. Estates of decedents who die during 2023 have a basic exclusion amount of $12,920,000, up from $12,060,000 in 2022.
The tax provisions mentioned above aren’t the only ones impacted by inflation. The IRS announced tax inflation adjustments for many other deductions, credits, and thresholds in Rev. Proc. 2022-38. However, these examples should give you an idea of why it’s crucial to keep track of inflation-based changes to tax laws and adjust your tax planning accordingly to maximize potential savings. As always, please reach out if you need help planning for taxes or minimizing your tax burden.