Inflation and your taxes: What you need to know
Key inflation adjustments to tax items could affect how much you owe. These strategies can help.
“The good news for taxpayers is that federal tax brackets and many federal benefits are adjusted annually for inflation.”— Head of National Wealth Strategies, Chief Investment Office, Merrill and Bank of America Private Bank
WE FEEL THE IMPACT OF INFLATION as consumers every day, but did you know that rising prices could also affect your tax picture? “Inflation can be mixed news for taxpayers,” says Mitchell Drossman, head of National Wealth Strategies in the Chief Investment Office for Merrill and Bank of America Private Bank. Your tax bill could be lower — or higher — as a result.
And inflation isn’t the only factor to consider. Market volatility and rising interest rates, while disconcerting, may also create opportunities for tax-efficiency. Now may be a good time to speak with your tax advisor about how these forces could affect your tax picture for this and next year and ways you might consider responding, Drossman suggests.
A recent Wealth Strategy Report from the Chief Investment Office (CIO), “Inflation, Market Volatility and Rising Interest Rates: Tax Consequences and Favored Planning Techniques,” could help guide that conversation. Below are a few potential changes to be aware of:
Tax bracket and retirement savings adjustments could lower your federal tax bill
“The good news for taxpayers is that federal tax brackets and many federal benefits are adjusted annually for inflation,” Drossman says. “For instance, 2023 tax bracket income caps and the thresholds for determining capital gains brackets have increased, and the standard deduction will also be adjusted upwards.” In addition, caps on IRA and retirement savings account contributions have been raised for 2023, providing potentially higher tax deductions.1 Combined, these adjustments mean that you could potentially find yourself in a lower tax bracket — even if you received a raise this year.
But keep in mind that these changes may only apply to your federal taxes; not all states follow the federal model of adjusting for inflation, Drossman notes. “Many don’t adjust tax brackets, standard deductions or personal exemptions.” Ask your tax advisor about your state’s provisions.
Social Security adjustments could bump you into a higher federal tax bracket
Social Security benefits are adjusted as the cost of living increases. In 2023, recipients will receive an 8.7% increase in benefits, the highest in 40 years.2 “The last time we saw a bigger increase was in 1981,” says Drossman. The average increase over the past 22 years was about 2.3%,3 he notes. On the downside, Social Security benefits are not adjusted for inflation from a tax perspective. So higher benefits could not only expose a greater portion of those benefits to taxation but can also push some taxpayers into higher tax brackets. Read “Will Your Social Security Benefits Be Taxed?” to learn more.
Watch out for the 3.8% net investment surtax
Even at the federal level, some key tax provisions, such as the 3.8% net investment surtax for couples earning $250,000 and up (or $200,000 for individuals) are not adjusted for inflation, Drossman says. Nor is the $500,000 exclusion ($250,000 for individuals) from gain on the sale of a primary residence. With wages and prices rising in response to inflation, more Americans may be subject to the 3.8% tax or exceed the residence exclusion, Drossman notes.
4 strategies to discuss with your tax advisor
No matter where you land after all these inflation adjustments are factored into your tax situation, current economic and market conditions could make the following tax-aware strategies especially attractive.
“Converting to a Roth IRA at a time when your investments may be temporarily lower due to volatility could help reduce your tax obligation when you convert.”— Head of National Wealth Strategies, Chief Investment Office, Merrill and Bank of America Private Bank
Tax-loss harvesting. Considering recent market volatility, you may have experienced some losses. By selling those assets, you could potentially use them to offset current or future gains. Your tax advisor can explain some important caveats to this strategy, Drossman adds.
Roth IRA Conversion. “If you’re thinking about converting from a traditional IRA to a Roth IRA, 2023 might be a good year to do so,” says Drossman. But you’ll have to pay tax on any previously untaxed IRA contributions and gains when you convert. “Converting to a Roth IRA at a time when your investments may be temporarily lower due to volatility could help reduce your tax obligation when you convert,” Drossman notes. For a unique set of taxpayers, 2023 could be an especially good year to convert to a Roth IRA, he adds. In the final days of 2022, the SECURE Act 2.0 became law. This Act increased the age for mandatory retirement plan distributions to age 73 effective January 1, 2023. Without the need to take a mandatory distribution, certain taxpayers may be in a lower tax bracket, providing an ideal time to convert to a Roth IRA.
Lifetime gifts. The current $10 million lifetime gift tax exemption is indexed annually for inflation. For 2022, the exemption stands at $12.06 million and will rise to $12.92 million in 2023. But in 2026 the exemption is scheduled to drop to about $6.5 million, Drossman notes. “If you own assets that have declined in value, now may be a good time to include those in your gifting plans,” he says. Temporarily reduced values could enable you to give that much more without triggering gift taxes, he says.
Trusts. “Depending on your financial goals, a variety of trust strategies may also be worth considering at a time when equity values are lower and interest rates have risen,” Drossman says. If you have existing trusts intended to last a long time that are not yet exempt from generation-skipping tax (GST), the current lower valuation environment may be a good time to consider allocating your GST exemption to those trusts.
Read the full report for a more detailed explanation of these and other strategies. And keep in mind that taxes quickly become complex, Drossman advises, so be sure to speak with a tax advisor before making any decisions.
1IRS.gov, “IRS Provides Tax Inflation Adjustments for Tax Year 2023,” October 18, 2022.
2The New York Times, “Retirees Are Getting an 8.7% Cost of Living Raise, the Biggest in Decades,” October 13, 2022.
3Associated Press, “Social Security Payments Set for Big Increase. What to Know,” October 12, 2022.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.