The cost of living as measured by the Consumer Price Index (CPI) was up 7 percent year-to-year in December, the largest increase since 1982, with no end in sight.
Inflation reduces your purchasing power, meaning you'll spend more for groceries and gas and just about everything else it takes to cover your living expenses. To make matters worse, it'll also affect how much you pay in taxes.
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There are various ways that a higher inflation rate will affect your tax bill.
Despite the rapid rise in housing prices and related property taxes, the cap on the deduction for state and local taxes remains at $10,000.
Income Bracket Creep
The federal tax code has seven income tax brackets, with each one taking a higher percentage of your income. As you earn more, you pay a higher percentage of your income, up to a maximum of 37 percent. The fear is that if you receive a raise, it may be wiped out by moving you into a higher tax rate bracket.
Fortunately, the IRS increases the dollar amount of the tax brackets each year in addition to adjustments to the standard deduction and personal exemptions to account for inflation. This reduce the effect of changing tax brackets on your federal income tax.
However, this isn't true of many states. According to the Tax Foundation, 13 states and Washington D.C. don't adjust their tax brackets for inflation. Plus, 10 states don't change their standard deduction, and 18 states don't index their personal exemption.
Consider also: How Does Inflation Affect the Value of Money?
Capital Gains Taxes Exemption for Homeowners
Homeowners are entitled to a capital gains exemption of $250,000 for single taxpayers and $500,000 for married couples if they meet certain requirements and purchase another home.
However, these amounts have not been adjusted since 1997 to reflect the effects of inflation. If they had been indexed to inflation, these exemptions would now be over $400,000 for single taxpayers and over $800,000 for couples.
Deduction for State and Local Taxes
Despite the rapid rise in housing prices and related property taxes, the cap on the deduction for state and local taxes remains at $10,000. Taxes in excess of this amount will not be deductible on your federal tax return.
Consider also: Why You Should Care About Shadow Inflation
Homeowners’ Deduction for Mortgage Interest
In its efforts to reduce inflation, the Federal Reserve Bank will gradually increase the federal funds rate. As a result, mortgage interest rates will rise, and homeowners will be paying more in interest. In addition, home prices have shot up dramatically in the past year. This means homeowners will be paying more in interest as they purchase higher-priced homes.
Unfortunately, the IRS has a cap of $750,000 on the amount of mortgage debt when it comes to deducting interest. If your mortgage is higher than this amount, you won't be able to deduct the excess mortgage interest.
The Social Security Administration adjusts its benefits each year for inflation. However, it hasn't adjusted the income level at which you start paying taxes on 85 percent of your Social Security payments. That amount has remained at $34,000 for single filers and $44,000 for married filing jointly since 1994. If this income threshold had been adjusted for inflation, it would be over $60,000 in 2022 for single filers, and more than $80,000 for couples, according to Fox Business.
Investment Income Surcharge
The threshold incomes that trigger the 3.8 percent surcharge on net investment income put in place by Obama in 2013 have not changed. Single taxpayers with adjusted gross incomes above $200,000 and couples with adjusted gross incomes above $250,000 will pay this surcharge on their net investment income above these thresholds.
If these threshold incomes had been adjusted for the impact of inflation, the surcharge could have been reduced or possibly eliminated.
Consider also: How to Convert Annual Inflation to Monthly Inflation
Now for some good news. The amount you can deduct to add to your 401(k) has been adjusted as inflation rises. The tax-deductible amount that taxpayers under age 50 can contribute to their 401(k) has been increased from $19,500 to $20,500 in 2021. This is roughly a 5 percent increase.
- CNBC: Here’s How Rising Inflation May Affect Your 2021 Tax Bill
- IRS: IRS Provides Tax Inflation Adjustments for Tax Year 2021
- Fox Business: How Inflation Eill Impact Your 2022 Taxes
- Tax Foundation: As Inflation Rises, So Will Tax Bills in Many States
- IRS: Questions and Answers on the Net Investment Income Tax