Inflation may save you money on your taxes

High inflation has taken an obvious toll on the cost of groceries, new cars and rents, among other things. But it may also help to know that, in addition to a big boost to Social Security payments, inflation could help save money on your federal tax bill next year.

That's because the federal government annually adjusts many elements of its complex tax code, including the standard deduction and tax brackets, to reflect inflation and avoid so-called stealth tax increases.

The adjustments also mean you can contribute more next year to retirement savings and other accounts that offer tax breaks, like health savings accounts.

Over the past 10 years, inflation was modest, so annual tweaks were small, said Kyle Pomerleau, a senior fellow at the American Enterprise Institute, a center-right think tank.

But this year, inflation hit a 40-year high. So the upward adjustments to various tax provisions for 2023 are expected to be significant — about 7%, more than double the 3% in 2022, according to projections by Pomerleau and others.

This year, the middle federal tax rate of 24% applied to ordinary income over $89,075 for a single filer and over $178,150 for a couple filing jointly. Next year, the income thresholds for that bracket are projected to increase to about $95,375 for single taxpayers and $190,750 for couples. (The Internal Revenue Service usually announces official numbers in late fall.)

A quick review: The federal government uses a progressive, or graduated, income tax system. Marginal tax rates ranging from 10% to 37% are applied to income in seven ranges, or brackets. The portion of your income falling into each bracket is taxed at the applicable rate. The average, known as your "effective" tax rate, is lower than your top marginal rate.

If the bracket boundaries weren't periodically adjusted for inflation, more of your income would move into a higher bracket, increasing your tax bill — even if your real income hadn't kept pace with the cost of living. Tax nerds call this "bracket creep."

Taxpayers whose income was near the upper edge of a bracket might see some or all their income pushed into the next, higher bracket if the thresholds weren't updated, said Edward Karl, vice president of taxation with the American Institute of Certified Public Accountants.

"If it wasn't adjusted, they would say, 'What the heck happened on my tax return?'" he said. "That's a big tax increase."

To avoid bracket creep, the government began adjusting, or indexing, tax brackets for inflation in the early 1980s, after a long period of raging inflation.

Daniel T. Massey, a principal with Walz Group, an accounting firm in Lititz, Pa., said people whose income had kept pace with inflation would see no change in their tax bracket, while someone with a stagnant or fixed income might have a lower tax bill because of the inflation adjustments.

Massey gave this example: A single filer in 2021 who earned $100,000 and took the standard deduction would have paid $15,009 in taxes, for an effective tax rate of 15%. Under projected brackets for 2023, a taxpayer with the same income would pay $14,383 — a saving of $626 — for an effective rate of 14.4%.

The standard deduction, which reduces your taxable income without requiring that you itemize deductions, is expected to rise to $13,850 next year from $12,950 this year for single filers and to $27,700 from $25,900 for couples.

Here are some questions and answers about income tax inflation adjustments:

How will inflation adjustments affect retirement and health account contributions?

Next year, you'll be able to contribute an estimated $6,500 to an individual retirement account, up from $6,000 this year. Limits are $1,000 higher if you're over 50.

The maximum contribution to a flexible health spending account is projected to increase to $3,050 from $2,850 this year.

And if you have a health savings account, a tax-favored account available with high-deductible health insurance plans, you'll be able to contribute $3,850 as an individual and $7,750 for family coverage, up from $3,650 and $7,300 this year, according to limits confirmed by the IRS. (Catch-up contributions of $1,000, for people over 55, are not adjusted for inflation.)

Do states adjust their income tax provisions for inflation?

Many states have progressive income tax systems like the federal government. Minnesota is one of the states that adjusts tax brackets annually using an inflation factor.

Are there income tax provisions that aren't adjusted for inflation?

Yes. For example, the income threshold for paying the 3.8% net investment income tax, also known as the Medicare tax, is fixed at $200,000 for individuals and $250,000 for joint filers.