As inflation takes a toll on us all, the IRS avoids being part of the problem by adjusting the tax code. Let’s look at how inflation would affect a married couple’s taxes and how the 2023 tax code changes would keep that couple’s tax rate from rising. (You can read about the specifics of the IRS changes in the article How Inflation Can Impact Your Taxes.)
Inflation has been the highest in about 40 years. That means that if your income or investments goes up at the same rate or less as prices, you can’t buy any more stuff than you could before, even though your income and assets may have increased in dollars. This higher inflation has resulted in the IRS making adjustments in the tax code that are more significant than in prior years. For 2023, the IRS has applied approximately a 7% increase to the 2022 income tax brackets. Without adjustment for inflation, a higher income would produce a higher average income tax rate, as more income would be taxed at higher rates.
Many people think they pay tax on all income at their highest rate or the bracket they are in, but that is not true. It is important to understand the difference between marginal rate (tax bracket) and effective rate (average rate).
Let’s look at examples to understand both the difference between marginal and effective rates and the impacts of inflation adjustments:
- Assume a married couple filing a joint return earns $200,000 in 2022.
- The couple receives cost-of-living adjustments of 7% and earns $214,000 in 2023.
- They use the standard deduction of $25,900 in 2022 and $27,700 in 2023.
Figuring the Marginal vs. Effective Rate
In 2022, with income of $200,000 and taking a standard deduction of $25,900, taxable income would be $174,100. This puts them in the 22% bracket, according to the 2022 tax brackets, or a marginal rate of 22%, but they do not pay tax on all their income at that rate. Instead, they pay 10% on the first $20,550, 12% from $20,551 to $83,550 and 22% from $83,551 to $174,100. As you follow the example, you will find that they pay an overall effective rate of 16.96%.
In 2022, our couple with adjusted gross income (before certain deductions) of $200,000 using the standard deduction of $25,900 would have taxable income of $174,100 and would pay federal income tax of $29,536. That equates to an average/effective rate of 16.96% ($29,536 / $174,100).
Without inflation adjustments and $214,000 of income in 2023, the tax would increase to $32,815, an average rate of 17.45%. More tax would be paid on income that was intended to keep up with inflation. Without adjustment, the income would buy no more stuff than the year before!
With inflation adjustments applied to the brackets and a standard deduction that will also increase with inflation to $27,700, if income increased to $214,000 in 2023, taxable income would be $186,300, and the tax would be $31,601, an average rate of 16.96%, the same rate as 2022.
If the same couple had $200,000 of income in both years, the adjustments to the brackets would cause their income to be taxed at lower rates in 2023, and they would save $1,015 in taxes.
Switching Between the Standard Deduction and Itemized Deductions Affects Taxes, Too
The Tax Cuts and Jobs Act of 2017 limited state and local tax deductions to $10,000 and increased the standard deductions, making it more difficult for taxpayers in high-tax states like New York and California to itemize deductions. You can use one or the other, and if your itemized deductions are close to the standard deduction, you may be able to plan to increase tax deductions.
Your accountant should automatically take the higher of the two deductions, but if itemized deductions for a married couple filing joint are $27,000 in 2022, when the standard deduction is $25,900, and they remain the same in 2023, you will likely switch to the standard deduction of $27,700 to save a few hundred dollars of tax.
On the other hand, if itemized deductions will be close to the standard deduction, you will benefit from additional charitable deductions or from lumping several years of charitable deductions in one year and then switching back to the standard deduction in years when charitable contributions are smaller. This can be accomplished with a donor-advised fund (DAF) that will allow a large deductible contribution when itemizing in one year with distributions to charities you choose over several future years when you use the standard deduction.
Investment Advisory Services offered through Mazars USA Wealth Advisors LLC, a New York SEC Registered Investment Advisor. Securities offered through APW Capital, Inc., Member FINRA/SIPC., 100 Enterprise Drive, Suite 504, Rockaway, NJ 07866 (800) 637-3211 - Member FINRA/SIPC. Mazars USA Wealth Advisors LLC. is a separate entity from APW Capital, Inc.
The above article does not constitute legal, tax, accounting, investment or other professional advice. Recipients should consult their professional advisors for their own circumstances.
David Weinstock provides business succession, estate, insurance, tax, and investment planning services to high-net-worth individuals and business owners. His more than 28 years of experience are centered on delivering wealth advisory services to individuals and families. He specializes in complex estate planning matters, often integrating the efficient use of life insurance solutions to meet clients’ objectives. David has published in The CPA Journal and in Estate Planning Magazine and has been interviewed by the Wall Street Journal.
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