Every year, the IRS tweaks certain deductions to account for inflation. IRS inflation adjustments affect many parts of your taxes, including income tax brackets, standard deductions, and several other tax credits and deductions.
The changes discussed in this article will apply for tax year 2023, so you can expect to see these adjusted totals starting in the 2024 filing season.
What Are Inflation Adjustments?
The IRS makes inflation adjustments to various tax provisions each year to account for inflation. The adjustments ensure the tax system reflects increasing prices to soften the blow of inflation on both business & individual taxpayers.
Inflation adjustments may include modifying thresholds, deductions, and credits to keep them in line with inflation and maintain their real, or inflation-adjusted, value.
The IRS calculates adjustments using the Chained Consumer Price Index or C-CPI. This index measures consumers spending in response to price changes, providing an accurate measure of inflation’s impact on average cost of living.
If the IRS didn’t adjust deductions for inflation, the value of certain deductions & tax credits would gradually diminish over time, and taxpayers would be forced to pay out a larger inflation-adjusted share of their income in taxes.
IRS inflation adjustments also play a crucial role in preventing “bracket creep,” where taxpayers may be pushed into higher tax brackets due to inflation rather than an increase in real income. These adjustments ensure the income thresholds for each tax bracket rise in line with inflation. The adjustments also help maintain the real value of tax deductions and credits, which would decrease in effectiveness over time without such adjustments.
By aligning with inflation, the IRS ensures fair taxation, preventing taxpayers from being penalized due to the decreasing value of money over time. In addition, they also keep the tax system balanced and equitable for both individuals and businesses.
Key Inflation Adjustments for Tax Year 2023
On that note, several categories of inflation adjustments are especially impactful for individual returns.
Individual Tax Brackets
The annual increase in tax brackets is important because it adjusts for inflation, ensuring taxpayers are not pushed into higher tax brackets or pay more in taxes simply due to increases in the cost of living rather than an increase in real income, thereby maintaining the tax system’s fairness.
Along with the tax bracket increases, the 2023 increase in standard deductions will lower your taxable income if you do not itemize. The 2023 standard deductions are:
Single and Married Filing Separately: $13,850
Married Filing Jointly: $27,700
Head of Household: $20,800
Child Tax Credit
The child tax credit did not change for 2023. Taxpayers can receive up to $2,000 for each dependent under the age of 17 (of which $1,500 is refundable). For other dependents, the IRS limits the credit to $500.
The IRS phases out the child tax credit for high-income taxpayers.
Retirement Plan Contributions
Because of inflation, taxpayers can save more money for retirement in 2023. The 2023 401(k) limit is $22,500, and taxpayers over the age of 50 can contribute an additional $7,500.
The annual IRA contribution limit increased to $6,500. Taxpayers over the age of 50 are eligible for an additional $1,000 contribution.
Capital Gains Tax Rates
Along with the tax bracket increases for ordinary income, the tax brackets for long-term capital gains also increased. Note that long-term capital gains are subject to favorable tax rates starting at $0, depending on your total income.
How Do Inflation Adjustments Affect My Taxes?
Inflation adjustments can have a significant impact on your taxes. Let’s break it down into simpler terms. Imagine that each year, you climb a ladder of income called tax brackets. Each step on the ladder represents a different amount of money you earn, and the higher you climb, the more taxes you pay.
That’s why the IRS adjusts these steps or “tax brackets” for inflation each year. In short, the IRS won’t move you into a higher tax bracket just because of inflation. They also adjust the value of deductions and credits. These are the parts of your income that you don’t have to pay taxes on. By adjusting deductions and credits for inflation, their value stays the same. Furthermore, you can continue to lower your tax bill with them.
Let’s look at an example of a single taxpayer who makes $50,000 in 2022.
- Total income: $80,000
- Standard deduction (2022): $12,950
- Taxable income (total income – standard deduction): $67,050
- Total Tax at 2022 tax rates: $10368
- After-tax income: $69,632
Now, in 2023, with the updated tax brackets and deductions (assuming no raise):
- Total income: $80,000
- Standard deduction (2023): $13,850′
- Taxable income (total income – standard deduction): $66,150
- Total tax at 2023 tax rates: $9,861
- After-tax income: $70,139
Although it doesn’t offset the full effect of inflation in the example above, the adjusted tax brackets do help lower the total taxes due.
So even if everything is getting more expensive because of high inflation, these adjustments are usually good news for taxpayers.
Final Thoughts on IRS Inflation Adjustments
Inflation adjustments conducted by the IRS play an indispensable role in our taxation system. Furthermore, protecting taxpayers against the potential financial challenges that may arise due to inflation. These adjustments recalibrate the tax brackets and the worth of tax deductions and credits to maintain the equity of the taxation system.
During periods of elevated inflation (like we’ve seen in 2022 and 2023), these adjustments become even more impactful. Accordingly, these adjustments provide taxpayers with a degree of relief. It’s worth noting that they might not fully compensate for the escalated cost of living. Grasping these adjustments and their implications on your taxes is essential to formulating a robust financial strategy for the future.
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