It has been said that the only two things that are certain in life are death and taxes. We’d like to add a third: inflation.
You can be certain that costs will go up year after year. Housing is the easiest trend to follow (a $300,000 house today only cost $180,000 a couple of decades ago), but you can find inflation everywhere.
Lots of factors can cause it to happen, and it’s rare for anything you purchase to get cheaper. (Even if the price goes down, the decreasing value of the dollar you spend on it may cancel any perceived “savings.”)
Since this new “third truth of life” is such a part of our world, especially as small business owners, we believe it’s important to know how to adjust for inflation. We think you deserve to know the real value of your money so you can make better decisions and build a stronger business.
Inflation and Taxes
Most economists believe that a certain amount of inflation is actually healthy. The Federal Reserve has traditionally tried to keep the inflation rate at around 2%. However, when inflation goes higher than that, people begin to notice how it affects day-to-day purchases.
This has been especially obvious In 2022 when inflation levels reached a 40-year high.
Inflation can also affect your taxes if adjustments aren’t made.
Consider this scenario:
- High levels of inflation begin sweeping the nation. As a result, the costs to manufacture and transport goods go up.
- Those costs are passed along to consumers in the form of higher prices.
- In order to be able to keep up with new costs of living, employees begin demanding higher wages.
- Employers raise salaries in order to adjust to the changing marketplace and prevent high levels of turnover.
It is possible that someone who is on the edge of a particular tax bracket could receive a slight raise that bumps them up into the next higher bracket. Then they could potentially wind up making no more money than before (or even less) because the tax rate of the new bracket cancels out the difference in salaries.
This is known as “bracket creep.” As the Tax Foundation defines it, brack creep is “when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions. Bracket creep results in an increase in income taxes without an increase in real income.”
Are Tax Brackets Adjusted for Inflation?
The IRS uses a progressive system of taxation for American citizens filing taxes. It includes 7 rates that do not change: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The adjusted gross income you report determines which rate is applied to your situation. For instance, in tax year 2022, 10% is for those making $10,275 or less and 37% is for individuals making $539,900 or more.
What does change, however, is the brackets that those rates are applied. These tax brackets are adjusted for inflation from year to year to help keep “bracket creep” from forcing people to pay more in taxes than they would otherwise. (It also prevents the government from being able to effectively raise taxes on U.S. citizens without going through the legislative process that our Constitution requires.)
Here’s how it works:
- In 2022, individuals making between $41,775 and $89,074 pay up to 22% in federal taxes on the parts of their salary that fall into that range.
- In 2023, that same tax bracket (22%) will be increased to apply to those making between $44,725 and $95,374.
- If you make $42,000 and your salary doesn’t change from 2022 to 2023, your tax bracket would move down next year from 22% to 12% (the next lower rate).
- By changing the tax brackets, the IRS adjusted for inflation and you’ll pay less.
In addition to changes in the tax brackets, the IRS is making inflation adjustments in several other areas as well (60 provisions in all) that will take effect in the upcoming tax year 2023.
- Standard deduction increases – up $1,800 for married filing jointly, $900 for individuals, and $1,400 for heads of households
- Alternative minimum tax exemption of $81,300 that begins to phase out at $578,150 for single filers (higher for married couples filing jointly); a $5,400 increase from 2022
- Earned Income Tax Credit maximum of $7,430; up from $6,935
- Employee FSA salary reduction limit goes up slightly to $3,050
- The annual exclusion for gifts will be $17,000; it’s been at $16,000 since 2021
- Medical savings account Increases in deductible and maximum out-of-pocket limits (details of which can be found in this IRS news release)
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How to Adjust for Inflation Using an Easy Inflation Rate Formula
But how do you (or the government) know how much to adjust for inflation, exactly?
CNBC wrote an article back in the summer on how to calculate your personal inflation rate that sheds some helpful light on the question.
We’ve already mentioned that national inflation is at the highest levels ever in the past 40 years. Compared to last year, goods and services are an average of 8.6% higher today. You’d have to go back to 1981 to find numbers like that.
But your personal situation may be different. Here’s how CNBC recommends adjusting for inflation with your personal (or business) finances:
- Add up all of your expenses from the past year. This is easy if you’re already working from a budget. (If you need help setting one up, a post we did a couple of years ago on how to win in the new year with solid budgeting habits will make it easy.)
- Do the same for last year.
- Subtract the totals and divide them by the current year’s expenses.
If you spent $60,000 this year and $50,000 last year, the difference is $10,000 (we’re accountants who appreciate easy math). If we divide $10,000 by $60,000, our personal inflation rate in this example is 17%…quite a bit larger than the current national average of 8.6%, which tells us that we’ve got some work to do to bring our expenses under control.
Inflation Rate Formula
For a way to quickly see how the value of something has changed over time, check out this Inflation Calculator from the U.S. Bureau of Labor Statistics. It can be quite an eye-opener and a little scary when you realize how much more expensive things could get if inflation isn’t brought under control soon.
Partner With a Trusted Guide
When you’re trying to stay on top of the constantly changing world of taxes, it can quickly become overwhelming. Fortunately, you don’t have to live that way.
Our team of tax experts is ready to partner with you and guide you through the entire tax process from start to finish. We’ve been doing it for over 40 years, so you know you’ll be in good hands. Schedule a call today to learn more and breathe a little easier.