taxes

How Inflation Can Impact Your Taxes

Record high inflation is driving up the price of everything from gas to groceries, but the impact of inflation in the U.S. on federal tax brackets and some tax credits might not be all bad.

Inflation. Inflation. Inflation. You’re hearing and thinking about it a lot lately – especially when you go to the store for “just a few items” and see a sky-high amount on your receipt. That’s because inflation in the U.S. is currently at a 40-year high of 9.1%, according to a recent Bureau of Labor Statistics report.

That means that when the COVID-19 pandemic first began, you were probably paying around a $1.34 for a dozen eggs, while those same eggs now might cost $2.05 or more. And though we won’t be paying more for things like food, houses, cars, and gas forever, this inflationary period is expected to hang on for a while.

Thankfully, with federal income taxes, inflation might not have the same harsh impact. That’s because the IRS makes annual adjustments to certain tax provisions. When inflation is high, like it is now, those adjustments can effectively increase the value of some federal tax credits and deductions.

It's important to note, however, that inflation adjustments may not create a huge change in your tax bill or tax refund – if you’re expecting one. But it is still important to know which tax deductions and credits are adjusted for inflation. That knowledge might help your tax planning and that planning might help you save some money at tax time.

Tax Brackets

To understand the relationship between inflation and federal income tax brackets, it is helpful to appreciate what inflation is and what’s causing it to be so high right now.

Inflation is essentially an increase in the price of goods and services, coupled with a reduction in the value of money. It’s measured by an index that compares the prices of various goods over time (take for example, the cost of eggs mentioned in the introduction).

While inflation is driven by varied market forces, the record high inflation in 2022 is being caused by factors that converged during and after the COVID-19 pandemic. For example, soaring consumer demand for goods and real estate, supply chain issues and shortages, strong job growth, and increased wages.

Even with high inflation though, the seven federal income tax rates don’t change from year to year. They are: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. But the federal income tax brackets tied to those rates are inflation adjusted on a yearly basis. So next year, you may feel like you received a bit of tax break even if your taxable income essentially stays the same. That's because you could end up in a lower tax bracket with the lower tax rate that goes with it.

In 2022, for example, single filers with $41,776 to $89,075 of taxable income are in the 22% federal income tax bracket. In 2021, that bracket applied to single filers with taxable income from $40,526 to $86,375. So, if you have $41,000 of taxable income in both 2021 and 2022, you will move from the 22% federal tax bracket to the 12% bracket when you file your 2022 tax return. Because the tax brackets are inflation adjusted, the 12% tax bracket ends up applying to single filers making $10,276 to $41,775 for 2022.

If high inflation hangs on for a while, the inflation adjusted tax brackets for 2023 could be even more favorable for some people. Also, you might avoid so-called “bracket creep,” which happens when a person’s income has basically stayed the same, but they still end up in a higher tax bracket.

Standard Deductions

Standard deductions are also adjusted to account for inflation. Those changes might help reduce your tax bill if you don’t claim itemized deductions.

For 2022, the IRS increased the standard deduction for different filing statuses (e.g., single, head of household, married filing jointly, etc.) by a little more than 3%. That's significantly higher than the rate of increase for the 2021 standard deduction amounts.

So, for the 2022 tax year, the standard deduction is $12,950 if you are single. In 2021, it was $450 less. For a married couple filing jointly, the 2021 standard deduction was $25,100. In 2022, it increased by $800 to $25,900.

401(k) and IRA Contribution Limits

Limits on how much you can contribute to your 401(k) are also indexed for inflation. This means that if you contribute to your workplace retirement account, which already reduces your taxable income, you may be able to contribute more each year—particularly when inflation is high.

The 2022 contribution limit for 401(k) plans is $20,500 – up $1,000 from the limit that applied the previous two tax years. If you are at least 50 years old, you can contribute an additional $6,500 in "catch-up" contributions in 2022, for a total of  $27,000.

If you're wondering about individual retirement accounts, IRA contribution limits unfortunately didn’t increased for this year. Total contributions to traditional or Roth IRAs remain limited to $6,000 in 2022. If you’re age 50 or older, the maximum “catch up” contribution is $1,000, for an annual total of $7,000.

There is some good news for IRAs in 2022, however. The income ceilings for Roth IRA contributions were adjusted up because of inflation. As a result, the 2022 income limit for making Roth IRA contributions is now $214,000 for joint filers and $144,000 for single filers (compared to $208,000 and $140,000, respectively, for 2021).

Capital Gains and Depreciation

In addition to high prices for common goods like food and gas, inflation also raises the cost of many capital assets likes houses and cars. And because the IRS doesn’t index capital gains for inflation, when inflation is high, capital losses are essentially multiplied.

When it comes to paying taxes on capital gains, the income thresholds for the long-term capital gains tax rates are adjusted each year for inflation. As with ordinary income tax rates, if your taxable income essentially stays the same, you may be able to avoid bracket creep by staying out of the 20% capital gains tax bracket.

The value of depreciation deductions for certain assets can also decline in periods of high inflation. But for 2022, the IRS raised depreciation limits for passenger cars, for example. First year depreciation increased last month to $19,200 for the first tax year the vehicle is in use. That is up $1,000 from 2021. Depreciation limits for succeeding years of passenger vehicle use also increased slightly from last year.

Health Expense Accounts

If you are enrolled in high deductible health plan, a health savings account or HSA, offers a tax-free way to pay for qualified health expenses and to potentially grow your retirement savings. An additional positive is that the tax-deductible amount that you can contribute to your HSA is adjusted annually for inflation. For 2022, the contribution limit for individuals is $3,650. For families, the limit is $7,300. If you are 55 years or older, you can advantage of the “catch-up” contribution of $1,000. In that case, the 2022 contribution limit totals are $4,650 for individual coverage and $8,300 for family coverage.

Because of inflation, the HSA contribution limits for 2023 will be adjusted upward by $200 for individuals and $450 for families. For those of you who are 55 or older, the catch-up contribution will stay at $1,000.

 Flexible Spending Accounts: Health FSA annual contribution limits are also inflation adjusted. Those adjustments can help stretch the value of the money you use to pay for qualified out-of-pocket health expenses. The FSA contribution limit increased in 2022 to $2,850--up $100 from $2,750 in 2021. 

Child Tax Credit, Earned Income Tax Credit, and Social Security

Numerous other tax provisions can be impacted by inflation depending upon whether they're inflation adjusted. A few of those are highlighted below.

  • The Child Tax Credit: The $2,000 Child Tax Credit is not currently adjusted for inflation, but the refundable portion of the credit is. For 2022, the IRS increased that by $100 to $1,500.
  •  The Adoption Credit: If you’re adopting a child, the IRS slightly increased the 2022 maximum credit for adoption expenses from $14,440 to $14,890.
  • Earned Income Tax Credit: The EITC is designed to reduce the tax liability for low-to-moderate-income families. The maximum credit amounts, phase-out ranges, and investment income limits are all adjusted annually to account for inflation. But there are many different EITC amounts for different categories of taxpayers. So, if you think you qualify for the EITC, be careful when you calculate the amount, or consult a tax professional if you're not sure.
  • Social Security Benefits: Income limits for taxing Social Security benefits are not adjusted for inflation. However, the benefits you receive do get a cost-of-living adjustment that can increase your income. For 2022, that adjustment increased to 5.9%, which is a record high that could be even higher in 2023. This could be important because, depending on the amount of your other taxable income, up to 85% of your Social Security may be taxable.

Proposed Inflation Relief

A plan to adjust additional tax credits for inflation to help low- and moderate-income taxpayers was recently introduced in the Senate. Although, as of now, it is unclear whether the bill can earn enough bipartisan votes to pass.

But stay tuned: If the proposed Family and Community Inflation Relief Act is approved, popular tax credits including the child tax credit and non-child dependent credit, the American Opportunity tax credit, and the Lifetime Learning credit, could be inflation adjusted. Tax deductions for student loan interest and charitable mileage would also be indexed for inflation for eligible earners. As previously mentioned, in this time of record-high inflation in the U.S., that could effectively increase the value of those tax breaks.

What You Can Do

Unfortunately, there isn’t a lot that most of us can do about the high inflation rates in the U.S. right now. But because inflation can impact tax brackets, income limits, tax deductions and tax credits, you should keep an eye on any IRS adjustments for tax breaks that you typically claim; and consider, with your tax preparer, whether those changes might have a positive, negative, or no impact your next tax bill.

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