Death, taxes, and inflation: three financial topics people generally like to bury their head in the sand about and pretend don’t exist. As financial planners, much of our job is helping our clients handle these tough topics, and luckily (or unluckily) for anyone reading this post, we’ll be touching on all three.
Inflation has been top of mind for most people these days. It’s hard to look at prices anywhere and not see the impact of inflation. But one place where we may not see the effects of inflation directly is in our taxes paid. The perception of many working individuals is that taxes paid from their paycheck go into some void, and when they file their taxes in the spring, they either receive a refund or owe some money. There is little thought or analysis as to how or why the numbers end up as they do.
As planners, we like digging into the numbers, and many of us — as insane as it sounds — enjoy tax planning too. This year may be creating a perfect storm of factors in which inflation will be hitting individuals’ taxes more than in most years. Here’s what you should know about how inflation may impact the amount of tax you pay this year.
Tax Brackets
The US tax code is quite complex and is made up of many different types of taxes. But when people think about taxes, they’re often referring to their tax bracket (marginal tax rate), so we’ll start there.
Tax brackets are bands of income that are taxed at a certain rate. The income tax rate is graduated, which is a fancy way of saying that when you enter a new tax bracket, only those next dollars — not all the dollars before — are taxed at the new bracket’s rate.
Example: Suzy earns $50,000 of income a year. The first $25,000 is taxed at 10%, and the next $25,000 is taxed at 20%. Her first $25,000 of income is in the first bracket, so her total tax on that income is $2,500 ($25,000 * 10%). Her next $25,000 falls into the next bracket, so her tax on the next $25,000 is $5,000 ($25,000 * 20%). The total tax on this income is $7,500.
Tax brackets are one of the aspects of taxes that do increase with inflation. So, depending on inflation from when it was last calculated, the brackets will increase to account for inflation. Beyond tax brackets, this is also true for the standard deduction and retirement plan contribution limits. The theory is that as inflation increases, the brackets and main deductions from income (the standard deduction and retirement plan contributions) increase with it, as does income. So as long as relative income remains the same, taxes remain similar as well (all things being equal of course).
However, theory and reality often don’t align, and tax brackets can fall in this category. There are two main issues with the typical inflation calculation when it comes to tax brackets. First, the adjustments to tax brackets for the following year are announced in August. So, the adjustments for 2023 will be calculated in August 2022. Much of the acceleration of inflation began in the second half of 2022, which won’t be included in the tax bracket inflation adjustments. Second, adjustments to the brackets are based off of chained CPI , not the CPI (consumer price index) we see in the news headlines. Based on the way chained CPI is calculated, it does not always increase as much as regular CPI, and therefore the tax bracket adjustments may not be commensurate with actual inflation.
Long story short, because of these factors, tax brackets may not truly reflect what inflation is or how much wages have increased or will increase. This means that all things being equal, even if your wages rise to match inflation, your tax bracket may not. This may mean you will be paying more in income taxes as a percentage of your income this year.
Social Security and Medicare Taxes
Other taxes working Americans see taken out of their paychecks are Social Security and Medicare. Inflation and wages are usually somewhat linked: As inflation increases, wages tend to rise. This wage increase means that many workers will be paying more for Social Security and Medicare.
Social Security tax is split between the employee and employer at 6.2% each (12.4% total). This 6.2% tax is capped at $147,000 of wages earned in 2022. If you earn more than that, you don’t pay any additional Social Security tax. The amount of wages eligible for Social Security tax each year also increases for inflation. However, because wages tend to increase year over year, this means that most people pay more in Social Security tax every year.
Of course, if your income has traditionally exceeded the amount on which Social Security is taxed, this may actually be a benefit because less of your income will be subject to Social Security tax than it would be if the income cap increased at the same rate of inflation at the same time.
For Medicare taxes, on the other hand, there is no income cap at which the tax stops. Like Social Security taxes, Medicare taxes are split by the employee and employer, but at a much lower rate of 1.45% each (2.9% total). But if you are earning more money, you are paying more in total tax, and this is true regardless of income level.
Net Investment Income Tax (NIIT)
Unlike tax brackets, which, at least in theory, increase at the rate of inflation, other taxes don’t adjust for inflation at all. One of these taxes is the net investment income tax (NIIT). This is an additional tax for high-income individuals who have investment income (interest, dividends, capital gains, royalty income, etc.).
The tax is only assessed on taxpayers whose adjusted gross income (AGI) is over $200,000 if single or $250,000 if married filing jointly. The tax is an additional 3.8% on investment income. So, as an example, if you’re in the 15% capital gains tax rate, the actual tax on amounts over these thresholds would be 18.8%. Because AGI incorporates your total income (wages, investment income, a side business, etc.), you don’t necessarily need a significant amount of investment income to be subject to the additional tax. However, the additional tax only applies to whatever investment income you have over these amounts and not to all of your income.
What doesn’t get adjusted for inflation annually is the cap on income. As incomes tend to rise year over year, more and more individuals will find themselves subject to this additional tax on their investment income because the threshold doesn’t increase.
Home Sale Exclusion
Home prices around the country, and especially New England, have been skyrocketing. Thankfully for those selling their homes, as long as the home they’re selling has been their primary residence for the past two years (there are other stipulations as well), there is an exclusion that is applied to a portion of the gain from the sale. For single individuals, the gain exclusion is $250,000 and for married filing jointly it’s $500,000.
While these numbers seem large, depending on when you bought your home and where you live, these exclusions might not exceed the total gain. Any gain above these amounts is taxed as capital gains. Unfortunately for sellers, these exclusion amounts are not indexed to inflation and remain the same year after year. As home prices have continued to rise, more people may find themselves actually having to pay some tax on the sale of their home.
The gain is calculated by taking what the home sold for minus what it was purchased for plus any improvements. Improvements such as updating the kitchen, installing a deck, upgrading floors, or installing a new roof, among many other things, increase the home’s basis. Keeping good records of these improvements has become more critical to proving that the gain does not exceed those limits.
If you sold your home in 2022 or are planning to sell, make sure that you get your records in order for your 2022 taxes if the gain may exceed the limits. Otherwise, you may find yourself paying extra tax on the sale of your home when you didn’t have to.
Estate Taxes
The way estate taxes are currently calculated, only a small minority of taxpayers will ever pay federal estate taxes. For 2022, the federal estate tax exemption is $12,060,000 per individual (and essentially double that amount for married taxpayers). In addition to that, the amount of the exemption increases for inflation every year, so the exemption amount is scheduled to increase in the future.
Where estate taxes are much more likely to apply is at the state level. Not every state has an estate tax, but of those that do, many have thresholds significantly lower than the federal exemption.
Luckily, those living in New Hampshire do not need to worry about an estate tax. But our neighbors to the south in Massachusetts do have an estate tax. The exemption amount is only $1,000,000, and this does not increase year to year for inflation. This exemption includes investment assets such as retirement accounts, bank accounts, and investment accounts, but also property and life insurance proceeds. As discussed before, with home valuations skyrocketing, it does not take an exceptionally large retirement nest egg for someone to phase into estate taxes in Massachusetts.
Although no one enjoys thinking about their passing, it is inevitable (but hopefully in the distant future). Having a plan for your estate is crucial to a complete financial plan and considering estate taxes may be an important aspect of it as well.
Summary
Inflation is hitting our pocketbooks at the pump, the grocery store, and most other places we buy goods and services. But we often don’t think about it impacting our tax situation. Because of the way certain taxes are calculated and the timing of those calculations, many Americans may find themselves paying a larger portion of their income in taxes than they have in the past.
Taxes are one of the largest expenses most people pay over the course of their lifetime. Planning for this can save a taxpayer a significant amount of money. Understanding that your taxes, as the law is currently written, may be higher now and in the future may warrant adjustments to your tax-planning strategy.
If you need help with your tax planning or financial planning in general, please reach out to our team .
This is not to be considered tax or financial advice. Please review your personal situation with your tax and/or financial advisor. All advisors at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford, NH. Milestone work with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors .
