Many of the 145 million Americans who filed individual tax returns this year might feel like they just got a tax break.
Substantial inflation adjustments made recently by the Internal Revenue Service mean that taxpayers whose income today barely puts them in a given bracket will slip down a bracket to a lower rate in 2023. Some who stay in the same bracket will also pay lower tax bills. Both groups could owe the Treasury Department thousands of dollars less come filing season next April.
People may actually see savings with tax bracket adjustments
"In general, it means people will see savings," said Tim Steffen, the director of tax planning at Baird's private wealth management group in Milwaukee. The extra money could go toward retirement nest eggs – if, financial advisors say, higher consumer prices don't stick around and siphon it away. Barring that, it may seem like a tax break.
With its adjustments for next year, the IRS didn't change tax rates; instead, it pushed up by roughly 7% the income levels at which established rates kick in. That means "you'll have more income taxed at a lower rate than what you had before," Steffen said.
It's all due to the way in which wages, bonuses, commissions, capital gains, interest, dividends, and other income are taxed in the U.S.
The IRS taxes Americans along a progressive system with seven brackets, each with its own rate. Chunks of income are taxed at progressively larger rates that range from 10% to a top 37%.
For example, when someone says they're in the 37% bracket, it doesn't mean that all of their income is taxed at that top rate — it means that the top tier of their income is taxed at that rate.
A taxpayer's "effective" rate, a measure of how much money he sends to the IRS each year, reflects an average of all the rates that apply to their total taxable income.
A Baird calculation using a simplified example shows that a married couple with taxable income of $200,000 in both 2022 and 2023 will see a reduction in their federal tax bill of nearly $900 based on the recent adjustments.
A couple with $500,000 of income both this year and next would see their tax bill fall by over $3,700.
For single taxpayers at those same income levels, tax bills would fall by roughly $1,400 and $1,900, respectively.
In another example, Elliott Brack, the managing director of tax services at Manhattan West, an independent wealth advisory firm in Los Angeles, calculates that a married couple with a combined income of $675,000 this year would see $27,150 of the total subject to the top 37% rate. That rate kicks in this year once income hits $647,850.
But with the adjustments, Brack said none of the couple's combined income next year, assuming it stays the same, will be taxed at that top rate, which will kick in once income hits a higher $693,750. As a result, the pair will save around $4,200 in federal taxes next year, he said.
Deductions and exemptions
The standard deduction, which allows taxpayers to protect a chunk of their income from federal taxes, will rise next year to $13,850 for individuals and $27,700 for married couples, also a roughly 7% increase.
The IRS also boosted the amount of money that investors can exclude from their taxable estates in 2023, to $12.92 million from $12.06 million per individual.
The amount that a person can gift to another each year will rise to $17,000 from $16,000.
Will the 2023 tax adjustment help with rising inflation?
Each year, the IRS adjusts a host of tax-related provisions, including brackets, the standard deduction, Social Security and contribution levels for retirement accounts, to reflect the impact of rising consumer prices.
Inflation is running 8.2% this year through September compared to a year ago — 6.6% when food and fuel aren't included — and prices for things like rents and services are much higher.
The IRS seeks to reduce "bracket creep"
The IRS adjusts brackets annually so that taxpayers are less hurt by the "hidden" tax of inflation. That's so workers who get a raise to offset higher consumer costs don't find themselves pushed into a higher bracket.
When increased earnings are taxed at a higher rate but still buy the same amount of goods and services as before, the phenomenon is known as "bracket creep;" that's what the IRS seeks to prevent through its adjustments.
The value of the IRS's adjustments for 2023 comes down to how long consumer prices continue to rise. That’s something only time will tell.
It’s never too early to get your 2023 tax questions answered. If you need tax assistance – or any kind of tax resolution help, don’t hesitate to reach out to me or any of my Tax Problem Solver Team, and we can dive into whatever’s going on.
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