KEY TAKEAWAYS
- Almost all income thresholds and deduction amounts are increasing by 7% based on Chained CPI for the 2023 filing year.
- Despite the increase in tax income thresholds due to inflation, you may still owe more taxes over time due to “bracket creep” (possibly as soon as 2023).
- Preparing a formal tax forecast over several years can help mitigate the impacts of bracket creep.
You may have seen the headlines about the 7% increase in the income thresholds for tax brackets in 2023 (for taxes due in April 2024) and how it is going to save you big money on your taxes, but is it? If you have received a cost of living (COLA) adjustment that is the same or larger than the reported Consumer Price Index (CPI), you could be moved up into a higher rate and pay more taxes.
The increased standard deduction could offset some of that in 2023, but bracket creep will eventually push you into higher rates. Higher income levels might not even see a drop in 2023, as the standard deduction is so much lower as a percentage of their income. Bracket creep impacts all taxpayers and results in the IRS taking more of our money over time.
The Changes
In the face of the high inflation numbers being reported by the Bureau of Labor Statistics, the IRS has used a calculation provided to them by Congress to change tax brackets by increasing the income thresholds. However, some tax items, when passed into law, do not allow for inflation adjustments (more on that later), but for the items that do, the calculation roughly came to a 7% increase across the board.
Here is an overview of the changes:
Tax Brackets:
Standard Deduction:
The 6.9% change in the standard deduction is close to the increases in the income threshold:
There were similar increases to the flexible spending accounts limit (HSA & FSA), the Earned Income Tax Credit, capital gains tax brackets, as well as a bigger gift exclusion, an increase in the estate tax limit, and more. If you’re looking for all the nitty gritty details you can find a good breakdown on them here.
Due to using the word gritty, I am required by internet law to display a picture of Gritty.
Higher Brackets = Free Money?
OMG, that’s great, the IRS is giving away money to us hardworking taxpayers! And thanks for the pic of Gritty! But I watch a lot of M. Night Shyamalan, I see dead people, and I know there is a twist.
The twist in this story is bracket creep. It is the term used to describe the process whereby the government stealthily raises taxes by creating tax laws that cause more and more people to fall into higher tax brackets (or lose credits) as time goes on due to inflation. This process can be done one of two ways.
When Congress passes tax laws, they usually include an adjustment provision the IRS can use to increase the cap, typically a calculation for inflation, but Congress can, and does, pass tax laws without any adjustment provisions at all. The most infamous example is the Alternative Minimum Tax (ATM), which was set up by Congress in 1969 after it was discovered that twenty-one millionaires paid no US income tax at all. With no inflation adjustment factor built into the original AMT tax, as the years went on, more and more taxpayers began paying the tax: at its peak, 5.2 million. That’s a large increase from the originally targeted twenty-one! Only in 2013 was the AMT provision completely overhauled to adjust for inflation.
Another example of a tax without an inflation adjustment is the income threshold for paying the 3.8% net investment income tax, also known as the Medicare tax. It is currently fixed at $200,000 for individuals and $250,000 for joint filers, so every COLA adjustment brings new taxpayers closer and closer to paying it.
Even tax laws with inflation adjustments have sneaky tax bracket creep built in. The inflation calculation provided to the IRS has always trailed the more broadly cited Consumer Price Index (CPI), and the Tax Cuts and Jobs Act of 2017 made the problem worse. That law changed the indexing for tax provisions from the CPI to the chained CPI. Chained CPI attempts to account for the substitution effects caused by higher prices. Because of this, it usually produces a lower inflation rate than the conventional CPI, and the calculation for the IRS rate uses the average year-over-year gain from 12 monthly readings of this modified number.
The average monthly chained CPI methodology produced an inflation adjustment of 6.95%, which is why most of the tax bracket changes for 2023 returns are roughly 7%. This adjustment is below the 8% year-over-year increase in chained CPI and the 8.2% annual rise in the CPI as of September, which are better reflections of the price differences you are paying for the CPI’s selected basket of goods compared to last year.
Depending on what you spend on, inflation could be worse (or better). Here are the inflation numbers for home food purchases as of September according to the BLS:
Those numbers sure look bigger than the 8.2% headline figure!
Breaking It Down
I’m sure you have inferred from my tone that those numbers are bad, but why?
Readers of the WJL blog are smart and successful, and as such, many have received increases in total compensation (including bonuses) over the past couple years of at least the inflation rate. A salary increase equal to the inflation rate simply maintains your purchasing power and standard of living. As smart, hardworking, WJL readers your employers have likely rewarded you with more than just maintaining your standard of living but let’s work through an example of receiving an increase equal to the CPI.
Take loyal readers Brook and Alex, a newly married couple, who in 2022 filed jointly and made a combined $178,000 per year. Their marginal tax bracket was 22%.
In 2023, their employer, The Prince of Bel Air Records, gives them a cost-of-living adjustment. Prince does this because they were able to charge more for their records and didn’t want their employees to lose purchasing power and possibly leave for rival Kriss Kross Records. Still, Price rounds down and gives Brook and Alex an 8% increase. That increase only maintains the couple’s purchasing power and does not provide any increase in standard of living. Their combined salary is now $192,240. At the new brackets, even with the 7% increase, they are now in the 24% marginal bracket!
Since these are only the marginal brackets, only a small amount of income will be taxed at that level in 2023, but now every year they receive an increase, even if it is only to keep up with inflation, it will be taxed at the higher rate, netting the federal government an additional 2% of taxes.
That is bracket creep in action.
Yes, this does ignore the increase in the standard deduction but as income increases, the standard deduction matters less and less in the tax calculation.
Action Plan
The best course of action is to
- Know what your current tax bracket is
- Estimate what your tax rate will be in the future
- Evaluate options to reduce taxable income and manage tax brackets
Depending on how complicated your finances are, you may be able to do this in a spreadsheet. You will want to make sure you include all your sources of income: wages, bonuses, interest, capital gains, business, etc. for a total income. Then remove any deductions that may apply before you arrive at total taxable income. Using the first two pages of your 1040 tax return from last year can be a very good guide.
For any numbers that you are having a hard time estimating, start with the prior year number and increase it by the inflation rate discussed earlier.
Repeating that process for several additional years, we aim for four or five, will give you a good idea of your rates in the short term. For the longer term, you may need help because the biggest item to consider is what will happen to your tax rates when you are required to take minimum distributions (RMDs) from your taxable retirement accounts.
Having a multiyear forecast can help you decide the best years tax harvest losses, increase pre-tax contributions, perform Roth conversations, and other actions to fill-up lower tax brackets before being moved into higher tax brackets over time (which we have shown will happen with just COLA increases).
Effective long-term tax planning can make a big difference in the total amount of taxes you pay, which is why WJL provides both tax and financial planning together. Tax minimization is a sport that adds up the score across a lifetime, not just the current year. It often makes sense to lock in a lower rate now so you’re not charged more later.
Year-end tax planning season is here, and if you think you could use help, please reach out to us.
Until next time, spend less than you make, invest the difference in low-cost index funds, be kind to your neighbors, and you will succeed in reaching your financial goals and in making the world around you a happier place.
At WJL Financial Advisors, we can put together a personalized financial plan (including help working on a purpose) that will help you reach your goals. If you’re interested in hearing how we can help, give me a call at 215-880-1892 or email me at sean@wjladvisors.com.