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How soaring inflation may lead to a higher tax bill for retirees

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Why inflation could lead to surprise tax bills

Each fall, the IRS makes inflation adjustments for the coming year on a series of tax provisions. The tax authorities have reinforced federal income tax brackets for 2022 and adjusted many other provisions, including standard deductions, 401(k) plan limits and more.

But other provisions remain unchanged and are not adjusted for inflation, leading to higher levies over time.

“It’s a hodgepodge of things that get left out,” said certified financial planner Larry Harris, director of tax services at Parsec Financial in Asheville, North Carolina. “And it’s not just hitting wealthy taxpayers.”

Lower limits for taxes on social security benefits

“I think the intention was to have more Social Security benefits taxable over time,” said Leonard Burman, a research fellow at the Urban Institute and co-founder of the Tax Policy Center. “And that was a way to slow the bleeding out of the Social Security trust fund.”

The Social Security trust fund could receive more than $45 billion in tax benefits in 2022, up from $34.5 billion in 2021, according to program administrator estimates.

Fixed exemptions for profits from house sales

You may also pay higher taxes when selling a house.

Joint filers can exclude up to $500,000 of profits from capital gains tax and single sellers can shield up to $250,000, provided they meet the conditions ownership and usage testing. But those amounts haven’t changed since 1997, despite the fact that median home sales prices have more than doubled in the past 20 years.

Basically, it’s a way to phase in a tax increase or at least limit revenue costs.

Leonard Burman

Institute Fellow at the Urban Institute and co-founder of the Tax Policy Center

The profit margin for homes at the median price was 47.2% in April, according to real estate data company ATTOM, which translates to $103,000 in gross profit for a typical home. Of course, the profits can be higher depending on the market and the date of initial purchase.

These hard limits are intentional, according to Burman. “I think the intent was for this level of exemption to decrease in value over time,” he said. “Basically, it’s a way to phase in a tax increase or at least limit revenue costs.

High earners pay extra

Another fixed provision concerns the thresholds for a 3.8% supplement on investment income set up by former President Barack Obama.

The levy kicks in when modified adjusted gross income exceeds $200,000 for single filers and $250,000 for couples, and these floors have not adjusted, creating a tax hike for high earners each year, Harris said.

And the controversial $10,000 limit on the federal deduction for state and local taxes, known as SALT, hasn’t budged since 2018. House Democrats passed an increase to $80,000 until 2030 as part of Build Back Better, but the legislation is stalled indefinitely.

“It really hammers a lot of people depending on what state you live in,” Harris said.

Some state taxes do not adjust for inflation

Some filers may also have higher state tax burdens in places without inflation adjustments for tax brackets, standard deduction, or personal exemptions.

While 41 states and the District of Columbia tax wages, 23 have at least one significant non-indexed tax provision, according to a Tax Foundation analysisand 13 do not index any of these components.

This amounts to an “unlegislated tax increase each year”, according to the analysis, reducing wage growth and the return on investment, especially during periods of inflation.

While unchanged provisions can sting some taxpayers during times of inflation, it’s hard to assess the damage without tax projection, Parsec Financial’s Harris said, adding that most people’s returns have “too many ‘other moving parts’.