Source: Wall Street Journal
Inflation is back, at least for now, and that matters for your taxes.
In November, inflation rose 6.8% from a year earlier, nearly a four-decade high as measured by the Labor Department’s consumer price index. For new cars (up 11%) and fast-food restaurants (up 7.9%), the jump in prices was the largest on record.
It’s unclear whether inflation will continue or cool. But Americans can be certain that the higher inflation is, the more uneven its impact will be on taxes owed to Uncle Sam.
“Because of differences in inflation adjustments, some taxpayers will feel inflation’s impact more than others,” says Kyle Pomerleau, a senior fellow at the American Enterprise Institute.
Inflation indexing was enacted in 1981, after years of inflation as high as 14.8%. While taxpayers’ income had risen with inflation, tax brackets remained fixed. As a result, people owed higher taxes due to nominal, but not real, increases in income.
Responding to pressure, Congress indexed the income-tax brackets and some other provisions for inflation. But lawmakers didn’t index all tax provisions, and since then they have chosen to adjust some new ones for inflation but not others.
For example, two key provisions for home buyers and sellers lack inflation adjustments: the $750,000 cap on total mortgage debt for which interest is tax deductible (enacted 2017), and an exemption of up to $250,000 of profit for single filers and $500,000 for married couples (enacted 1997) on the sale of a home.
If lawmakers had adjusted the home-sellers’ exemption for inflation, it would now be above $411,000 for singles and $822,000 for couples. So if a taxpayer has large taxable gains from the sale of a highly appreciated home, that person will owe higher taxes due to inflation than a wage earner whose taxes have been adjusted for inflation annually.
Other notable provisions not indexed for inflation include the cap on the state and local tax deduction, typically $10,000 per return; the $3,000 deduction of net capital losses against ordinary income such as wages; and the thresholds for the 3.8% surtax on net investment income of $250,000 for married joint filers and $200,000 for singles.
For key inflation-adjusted tax numbers for 2022, see the tables at the end of this article. Here’s more about inflation effects for specific groups of taxpayers going into the new year.
Many wage-earners will see take-home pay bump up in 2022, according to Curtis Tatum, an executive with the American Payroll Association. That’s because the inflation factor used to adjust federal tax withholding tables has risen about 3% for 2022 due to inflation indexing, far more than last year’s factor of about 1%. The adjustment lowers the amount of taxes deducted from paychecks, raising take-home pay.
Why isn’t the factor even higher? One reason is that Congress changed the inflation measure in 2017 to one that’s often slower for many provisions. In addition, the Internal Revenue Service uses figures for the year ended Aug. 31 to figure the next-year’s tax tables, and inflation surged this fall.
A single filer with $80,000 of wages, no dependents, a simple return and biweekly pay could soon see about $5 extra per paycheck, according to Wolters Kluwer’s principal federal tax analyst Mark Luscombe. For joint filers with $200,000 of pay from just one earner and the same conditions, the biweekly bump could come to about $28.
Many people contributing to tax-favored retirement plans such as 401(k)s, IRAs and Roth IRAs for 2022 will benefit from inflation adjustments that are higher than those for income-tax brackets. That’s in part because Congress’s 2017 switch to an often-lower inflation measure as described above doesn’t apply to savings-plan limits. The inflation adjustments for savings-plans are also based on more recent data.
As a result, the top tax-deductible contribution to a 401(k) for savers under age 50 will rise to $20,500 from $19,500 in 2021, about 5%. For contributions to traditional and Roth IRAs, the limit will remain $6,000 for now for savers under age 50, due to rules preventing increases until there is a $1,000 increment. The income thresholds for these tax breaks will be higher for most taxpayers, however.
Social Security recipients
Higher inflation will boost Social Security benefits for 2022 by 5.9%, the most since 1982.
But higher inflation also raises taxes for many recipients. The income thresholds at which 85% of Social Security payments become taxable aren’t inflation-adjusted and have been $44,000 for joint-filing couples and $34,000 for single filers since 1994, according to Karen Smith, a retirement-policy analyst at the Urban Institute.
Ms. Smith estimates that if the thresholds were adjusted for inflation, they would be about $80,400 for couples and $62,200 for singles in 2022.
She adds that nearly 64 million adults will receive Social Security payments in 2022, with the payments taxable for about 30 million of them. If the tax thresholds were adjusted for inflation, she estimates that only 24 million recipients would have taxable payments.
Investors with taxable accounts
The 2022 brackets for reduced tax rates on long-term capital gains and many dividends are indexed similarly to brackets for ordinary income like wages.
But that doesn’t deal with all the issues inflation presents for investors with taxable accounts, says Mr. Pomerleau. Because the tax code doesn’t account for the portion of investment income that’s due to inflation, it can overstate taxable income.
For example, if a dividend rises from $5 to $5.10 per share in a period of high inflation, the entire amount is taxable even if real returns haven’t changed.
He adds that this issue poses less of a problem for investors with long-term capital gains, because the ability to defer tax until a sale, plus lower rates, can offset the effects of inflation. And there’s no capital-gains tax on investments held until death.