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Even More Taxing

Richard Connor

INFLATION HAS BEEN the big economic story of 2022. Steep increases in consumer prices have hurt families in many ways—some of which aren’t so obvious.

You’re likely aware of the hefty increases in borrowing costs, home prices, rents, gas prices and groceries. But here’s something else to consider: how inflation can lead to higher taxes.

Important parts of the federal tax code aren’t indexed for inflation. Result: If inflation leads to nominal increases in a family’s income, it could lead to larger tax bills at a time when many taxpayers are already contending with steeply higher consumer prices. That would be an ill-timed double whammy for many Americans. Consider eight examples:

  • Social Security benefits are taxed once a retiree’s “combined income” crosses certain thresholds, set at $25,000 for single taxpayers and $32,000 for married couples. Benefits are adjusted each year for inflation, but these thresholds aren’t. Depending on your benefit level, a larger chunk of your Social Security check could be lost to taxes.
  • High-income taxpayers often face the Medicare surtax. This surtax hits not only earned income, but also investment gains. The net investment income tax is an additional 3.8% tax levied on dividends, interest and capital gains. The Medicare surtax applies if your modified adjusted gross income exceeds $200,000 for single taxpayers and $250,000 for couples. These thresholds aren’t indexed for inflation. If inflation leads to an increase in your income, you might find yourself above the threshold level.
  • Inflation boosts both the interest income from inflation-indexed Treasury bonds and the principal value of these bonds. That’s the good news. The downside: These gains are taxed as ordinary income in the year they occur, unless you hold the bonds in a retirement account. That means high inflation will mean more taxable income for holders of inflation-indexed Treasurys, resulting in higher taxes. This is true even though bondholders don’t receive the inflation-adjusted principal value until they sell or their bonds mature.
  • Housing prices have soared over the past year, which might expose homeowners to unexpected capital gains taxes when they sell. In a recent article, I described the capital gains exclusion for the sale of a primary residence. A single filer can exclude up to $250,000 in capital gains on a home sale without paying taxes. A married couple can exclude $500,000. These amounts haven’t changed since 1997.

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  • Unlike housing prices, stocks most certainly haven’t soared in 2022. Still, if stocks prove to be the long-term inflation hedge that they’ve historically been, investors may find themselves paying capital gains taxes on large nominal gains—but modest after-inflation returns.
  • The child tax credit reduces the tax burden on families with children under age 17, but inflation could make the credit less effective. The maximum credit is $2,000 per child from 2022 to 2025. Inflation reduces the purchasing power of every dollar, so higher inflation will cause the real value of the credit to shrink.
  • Paying college costs? The income thresholds to qualify for both the American Opportunity Tax Credit and the Lifetime Learning Credit don’t adjust for inflation, which means some families will find they can no longer use these credits simply because their employer gave them a cost-of-living pay increase. What if you do qualify? Like the child tax credit, these education credits are now worth less in inflation-adjusted terms.
  • Many states don’t index their income-tax brackets for inflation. Of the 41 states that tax wages, 15 of them, plus Washington, D.C., do not automatically adjust their tax brackets for inflation. That means rising nominal wages could push taxpayers into higher brackets at the state level.

What can be done? John Goodman and Boston University professor Laurence Kotlikoff recently proposed several measures to reduce the tax bite caused by inflation. For instance, they recommended fully indexing the federal tax code for inflation and doing the same for the threshold at which Social Security benefits are taxed. They also proposed eliminating the payroll tax for anyone over Social Security’s full retirement age.

Their proposals won’t lower the inflation rate, but they would lessen the pain of inflation for many taxpayers and Social Security recipients. That strikes me as a worthy goal.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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OBX9397
OBX9397
2 months ago

Please allow me to throw in a related problem. (Not caused by inflation, but perhaps caused by a cause of inflation?)
 
Last year, the county in which I live did a revaluation of properties. Of course, this revaluation was based on property values in a huge sellers’ market, that may or may not be a bubble. At first, this did not bother me because I assumed the county and city would adjust their tax rates down in order to generate income in line with past years.
 
Whoops! I just downloaded by tax bill, and wow, was I wrong. The county rate stayed the same. The city lowered their rate a tiny bit. My property tax went up 43%.
 
I expect things to get interesting around here.

David Powell
David Powell
2 months ago

I Bonds differ from TIPS in one important way: taxes aren’t owed on interest income until the bond is sold.

Humble Reader
Humble Reader
2 months ago
Reply to  David Powell

Having recently bought an I-bond I remembered having a choice of reporting the interest every year, or waiting until the bond is redeemed. Check out https://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_itaxconsider.ht

William Perry
William Perry
2 months ago

Valid and timely tax matters to consider. Thanks for the article Richard.

So what other steps should we as individuals consider to mitigate the tax creep and cliffs caused by inflation?

A few thoughts –

For those who no longer have earned income consider the taxable impact of creep & cliffs on any Roth conversions before the conversion.

For those still working and covered by a work 401(k) increase or max out the elective deductible contribution and / or change a 401(k) Roth contribution choice to a traditional deductible choice to lower your AGI.

If still working and your income permits consider fine tuning your taxable income after year end by making a deductible IRA contribution to get below a tax cliff or bracket top or to avoid a IRMAA surcharge cliff.

Besides the current great rates the taxable interest on I-Bonds is not taxable until the I-Bond is cashed out or matures. Defer taxable recognition. I am moving my fixed income savings in that direction.

If over 70 1/2 and 72 make qualified charitable distributions from your traditional IRA to fulfill your charitable intents and satisfy your required minimum distribution requirements while lowering your adjusted gross income. Win, Win, Win. Watch for a tax trap if you make any deductible IRA contributions after age 70 1/2 as doing so may cause the QCD to be taxable.

Over age 72+ – If still working consider a trustee to trustee transfer from a traditional IRA or inactive 401(k) (ask current HR, read the SPD or plan itself) into the plan where you are an active participant if the plan permits. As long as you are actively working and not a 5% + owner of the business sponsoring the 401(k) you could avoid any RMD from that plan until after you stop active work. If you have a choice and desire continuing part time work with the same employer may result in delaying RMDs from that 401(k).

I hope these thoughts help.

Rick Connor
Rick Connor
2 months ago
Reply to  William Perry

William, thanks for the excellent reply. I was considering a follow-up article addressing some of these concerns, but you’ve covered it quite well. Thanks,
Rick

William Perry
William Perry
2 months ago
Reply to  Rick Connor

I am confident that congress will again move the goalposts in short order.

steveark
steveark
2 months ago

I don’t think the US government sees this as a problem. They see it as inflation proofing their tax revenues without having to overtly raise taxes. I doubt we will ever see the government do anything to “fix” something they see as a wonderful way to take in more money. Great post, a little frightening, but very instructional.

Edmund Marsh
Edmund Marsh
2 months ago

Richard, you make me think of the term “bracket creep” from the ‘70s. But, I was teenager then, and not really feeling the pain.

R Quinn
R Quinn
2 months ago

Great article Richard. Stuff we probably know but never think about in the aggregate. There is no escape from higher taxes. Problem is that to support all the things Americans want and politicians want to promise, taxes should be higher. USA is still one of the lowest taxed countries. Try getting Americans to believe that.

Harold Tynes
Harold Tynes
2 months ago
Reply to  R Quinn

The VAT in EU countries is a good example of what to avoid in taxation. https://taxfoundation.org/value-added-tax-2022-vat-rates-in-europe/

Harold Tynes
Harold Tynes
2 months ago
Reply to  Harold Tynes
Jo Bo
Jo Bo
2 months ago
Reply to  R Quinn

Well said. Though I may grumble on tax day, it’s important to not lose sight of the bigger picture.

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