The U.S. annual inflation rate climbed to 7.5% at the end of January, the highest surge since 1982. Though the Fed is planning on raising interest rates – which have been at near-zero since March 2020 – for the first time in two years to try and combat inflation, taxpayers are already feeling the sting of high consumer pricing. When inflation runs hot, here’s how it ultimately affects taxes.
How inflation affects income
High inflation has the potential to erode purchasing power, even if someone’s income increased over a period of time. In a very simple example, let’s say someone’s income was $50,000 in 2019 and is today $55,000. In theory, that increase in income could translate to an increase in overall wealth. However, due to inflation causing an increase in the cost of those goods and services, what happens is that $55,000 affords the same or less amount of goods and services as it would at $50,000.
Inflation’s effect on Income taxes
The tax system in the U.S. is progressive, which means the more you earn, the more you potentially get taxed. However, it’s based on marginal tax rates and brackets, so if your income lands in the 22% tax bracket, you’ll pay taxes at the 22%, 12%, and 10% rate depending on your income thresholds.
Each year, the IRS makes an adjustment on certain tax provisions to keep pace with inflation in the hopes of avoiding what’s known as “bracket creep”. Some of those adjustments may prove beneficial to taxpayers, such as a higher standard deduction, for example.
However, bracket creep occurs when the rate of inflation pushes taxpayers’ income into higher tax brackets than they would normally be. Consider this example from the Tax Foundation, where taxpayer Beth’s income was $50,000 in 2000 and $75,000 in 2020, and tax brackets are fixed:
“Beth faces a simple, two-rate tax schedule where a 10 percent rate is levied on the first $50,000 of her income, and a 20 percent tax rate is levied on income above $50,000. Suppose, now, that these bracket thresholds were adopted 20 years ago and have not changed since Beth was making $50,000. Even though Beth’s 2020 salary now buys her the same amount of goods and services, she has been pushed into a higher tax bracket, resulting in higher tax liability.”
What isn’t factored into inflation
However, there are other tax provisions that aren’t tied to inflation – but that can also hurt taxpayers. Consider the State and Local Taxes (SALT) deduction, which was enacted into law as part of the Tax Cuts and Jobs Act, and is currently capped at $10,000. As state and local taxes rise due to inflation, the cap has the potential to negatively affect more taxpayers because inflation was not taken into account.
Managing inflation and your taxes
Rising inflation has the potential to create higher tax bills and other issues for taxpayers. While we can’t control inflation, we can discuss and prepare strategies with tax planning and tax projections. Contact one of our tax professionals to discuss anticipating and minimizing possible tax liabilities.
The Team at Chatterton & Associates
Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither Royal Alliance Associates, Inc nor its representatives provide tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.