Investing News

Inflation at 40-year highs has a silver lining: It will lower taxes next year for the majority of workers whose wages haven’t kept up with rising consumer prices.

That’s based on the annual inflation adjustment—this year at nearly 7%—that the Internal Revenue Service (IRS) announced Tuesday for 2023 income tax brackets and other tax thresholds. The changes, legally mandated to offset an inflation side effect known as bracket creep, will result in reduced tax withholdings from paychecks starting in January.

Key Takeaways

  • The dollar amounts for federal income tax brackets are adjusted annually for inflation to counter so-called “bracket creep.”
  • The IRS has announced inflation-adjusted numbers for 2023 for more than 60 tax code provisions.
  • As a result, the personal tax deduction, maximum earned income tax credit, and inheritance tax exemption will increase about 7% in 2023.
  • Inflation indexing is based on the average of 12 monthly readings for the chain-weighted consumer price index.
  • Because wages haven’t kept pace with the CPI, paycheck tax withholdings should decline in 2023 for most wage earners.

Higher Standard Deductions, More Favorable Tax Brackets

The adjustment will increase the 2023 standard deduction. Single filers will see a $900 rise to $13,850. Married couples filing jointly go to $27,700—an $1,800 increase.

The lowest 10% federal income tax rate will apply to the first $11,000 in taxable income for single filers and the first $22,000 for joint filers, up from $10,275 and $20,550, respectively, in 2022.

Example of Tax Savings From Inflation Adjustment

The changes will produce the most savings for the highest income taxpayers: The top marginal tax rate of 37% will apply to single filers with income above $578,125 in 2023, up from $539.900 in 2022. That change alone will save single filers subject to the top marginal rate $764.50.

  • $578,125 – $539,900 = $38,225 in income subject to lower tax rate in 2023
  • $38,225 X 0.37 = $14,143.25 in 2022 income tax
  • $38,225 x 0.35 = $13,378.75 in 2023 income tax 
  • $14,143,25 – $13,378.75 = $764.50 in 2023 tax savings

Other Changes

The annual inflation indexing adjustment applies to more than 60 tax provisions, according to the IRS. Two key shifts: The maximum earned income tax credit for qualifying taxpayers with three or more children will increase to $7,430 in 2023, from $6,935 in 2022. The estates of those who die in 2023 will not be subject to the federal estate tax on the first $12.92 million in value—up from $12.06 million in 2022.

Inflation indexing isn’t all good news: Monetary penalties specified in the tax code, such as the penalty for failing to file a return, will also rise accordingly.

How the Inflation Adjustment Is Calculated

The annual tax changes are based on the chained consumer price index, an alternative to the standard consumer price index (CPI). Chained CPI better accounts for the substitution effects caused by higher prices and, as a result, tends to produce slightly lower inflation-rate readings than conventional CPI. The Tax Cuts and Jobs Act of 2017 shifted the indexing for tax provisions from the CPI to chained CPI.

Under the law, the IRS uses the average year-over-year gain from 12 monthly readings of chained CPI starting in August of the prior year to calculate the annual index gain. That methodology produced an inflation adjustment of 6.95%—below the 8% year-over-year increase in chained CPI and the 8.2% annual rise in the CPI as of September.

The Bottom Line

Most taxpayers will see savings as a result of the 2023 indexing changes because their income hasn’t kept up with inflation over the past year, even as it’s grown in nominal terms. Average weekly earnings were nominally up 4.1% in the year through September but down 3.8% after adjusting for inflation, according to the Bureau of Labor Statistics.

Articles You May Like

Small Caps: Unexpected Outperformance Could Drive Gains in a Hurry
How GE Vernova plans to deploy small nuclear reactors across the developed world
The AI Stocks Poised to Dominate the Market by 2025
These economists say artificial intelligence can narrow U.S. deficits by improving health care
Top Wall Street analysts pick 3 stocks for their attractive prospects