For more than a year now, Americans have been squeezed by the rising costs associated with high inflation. The effects of persistent volatility and declining purchasing power are being felt at the grocery store, the gas pump, and in investors’ portfolios.
According to the Bureau of Labor Statistics, the consumer price index (CPI) rose 0.4% in September and 8.2% over the course of last year. As the cost of living remains inhibitive going into 2023, the Internal Revenue Service (IRS) has announced new inflation adjustments for the coming tax year. Perhaps most notably, federal income tax brackets will shift up by 7%—the largest jump in years.
What will these changes mean for your finances? While they’re unlikely to result in a greater tax burden, they’re also not necessarily cause for celebration. Rather, these changes are merely meant to keep pace with today’s inflationary conditions. To understand the what, why, and how of these upcoming adjustments, we first need to grasp what inflation is and how it works. After that’s been established, we will break down each of the regulatory updates being made by the IRS in 2023.
What’s Inflation and How Does it Work?
Inflation refers to a widespread rise in prices that causes purchasing power to decrease for individual consumers as well as for businesses. Put simply, if everyday goods and services become more expensive, a dollar can’t stretch as far. Measures of inflation like the CPI aim to capture average price changes for a diverse “basket” of market sectors on a monthly and yearly basis. So, when the BLS reports the CPI rose 8.2% over the last 12 months, you can assume that figure represents an aggregate of prices from various market sectors. More specifically, energy and food prices rose 19.8% and 11.2%, respectively, while the cost of apparel only rose 3.7%.
Despite the rampant inflation we’re experiencing, the wages of American workers haven’t risen to account for their decline in purchasing power. In fact, wages have stayed virtually the same since the 1970s. While productivity has grown by 61.8% between 1979 and 2020, hourly pay has only increased by 15.9%, according to the Economic Policy Institute. When
the cost of living threatens to outpace workers’ take-home pay, they tend to spend less, ultimately leading to less growth for the economy at large.
What’s Driving Inflation?
The effects of inflation are relatively easy to understand, but its causes can be far more nuanced. It’s a phenomenon that’s often precipitated by a number of different factors, from bad fiscal policies and corporate greed to consumer psychology and market pressures.
When we look at what’s driving inflation today, it seems clear that it was kickstarted by the pandemic. The pandemic-imposed lockdowns put the world’s delicate supply chain under extreme stress, and further disruptions from the war in Ukraine and other instances of geopolitical instability have only exacerbated that stress and hampered the supply of goods. Meanwhile, demand remained relatively steady (excluding the 2020 stimulus shock), causing the price of products—and thus the cost of living—to rise.
What Changes is the IRS Making?
To mitigate the impact of inflation on Americans, the IRS has released a series of adjustments for 2023. These changes may prevent people from getting pushed into higher tax brackets if their income has risen with inflation, while also limiting the amount of tax revenue the government can bring in. Without these adjustments, the public could end up paying more taxes even though Congress hasn’t explicitly raised rates.
But how does all of this affect you? To reiterate a point made previously, these changes aren’t intended to be a tax cut or a tax increase; they’re simply meant to level the playing to account for inflation. But that doesn’t mean you won’t be impacted. Let’s take a look at some of the changes coming for the 2023 tax year.
Shifting Income Tax Brackets
Income tax brackets are receiving a 7% bump across the board. Note that federal income tax rates remain unchanged—it’s just the brackets themselves that are shifting. Here are the new tax brackets for next year, according to theIRS:
• 35% for incomes over $231,250 ($462,500 for married couples filing jointly).
• 32% for incomes over $182,100 ($364,200 for married couples filing jointly).
• 24% for incomes over $95,375 ($190,750 for married couples filing jointly).
• 22% for incomes over $44,725 ($89,450 for married couples filing jointly).
• 12% for incomes over $11,000 ($22,000 for married couples filing jointly).
– 10% for incomes of $11,000 or less ($22,000 for married couples filing jointly).
Additionally, the standard deduction for individual filers will increase to $13,850 and married couples filing jointly will have a standard deduction of $27,700 (up by $900 and $1,800, respectively). Should you decide against itemizing your deductions on your tax return, you can claim the standard deduction and subtract that amount from your taxable income for the year.
Rising Retirement Contribution Limits
The IRS is also raising the annual contribution limits for retirement accounts. Taxpayers who participate in a 401(k), a 403(B), most 457 plans, or the Thrift Savings Plan, will be able to contribute an additional $2,000 to their accounts in 2023, for a maximum contribution of $22,500. Those over the age of 50 will be able to contribute up to $7,500 in additional funds as a “catch-up” contribution.
IRA contributions are seeing their contribution limits increase by $500, which brings the annual cap to $6,500 for all IRA investors. Catch-up contributions for IRAs remain unchanged going into 2023.
These adjustments should allow retirement savers to get more dollars into their retirement accounts, which generally provide superior tax shelter compared to other investment accounts that don’t cap contributions.
Social Security COLA
For the vast majority of Americans who rely on Social Security for at least a portion of their retirement income, the Social Security Administration (SSA) has announced its intention to raise benefits by 8.7% next year. As part of the largest cost-of-living adjustment (COLA) since 1981, recipients of Social Security will see their monthly benefits rise by more than $140 starting in January. The average monthly payout should be roughly $1,827 per person, up from $1,681 in 2022.
The SSA is also making changes to the wage base and earnings limits for workers. The maximum amount of earnings that are subject to Social Security tax will rise to $160,200, meaning the additional 6.2% Social Security tax will not be levied on any earnings that exceed $160,200. Additionally, workers who earn more than $21,240 prior to full retirement age will have their Social Security benefits reduced by $1 for every $2 they earn in excess
of that amount. Workers who will reach retirement age in 2023 and earn more than $56,520 will have their benefits reduced by $1 for every $3 they earn in excess of that amount, but only until the month they turn full retirement age.
Bear in mind that these penalties only apply to the months and years prior to full retirement age, which is between 66 and 67 years old depending on when you were born. Upon
reaching full retirement age, you can earn as much income as you’d like without your Social Security benefits being impacted.
Annual Gift Exclusions
Finally, one of the most significant inflation-related adjustments coming in 2023 is an increase to the annual gift tax exclusion, which designates the amount you’re allowed to gift others (such as your children or grandchildren) each year free of tax. The new annual exclusion amount will be $17,000; an increase of $1,000 over 2021. For tax purposes, gifts are priced based on their fair market values, not the cash values you acquired them for. There’s no limit to the number of people you can make these annual gifts to, meaning you can give up to $17,000 to each of your children and grandchildren if you choose to.
If you’re feeling confused about any of these upcoming changes, just reach out to your financial professional for guidance. Your financial professional can help you prepare for 2023 and beyond.
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