How Inflation Impacts Taxes and Retirement Benefits

While the holiday season is ideally a time for family and friends, it is also a good time to review tax strategies for the current as well as the coming year. Tax planning includes possibilities such as tax-loss harvesting, choices of investment vehicles, order withdrawal optimization, and many others. Given the complexity of these considerations, it’s important to work with a trusted financial professional to best understand each approach and its implications. It’s also important to understand the economic climate’s effect on taxes, especially the impact of inflation. What should investors know as they plan for 2024?

While inflation is an implicit tax on consumers because it reduces the purchasing power of cash, it also has an impact on actual tax bills. This is because inflationary environments tend to drive higher wages, and left unchecked, this can lead to “tax bracket creep,” a phenomenon whereby growing nominal incomes push taxpayers into relatively higher tax brackets. To limit such distortions, the IRS adjusts federal tax brackets each year based on inflation rates.

Tax bracket thresholds are adjusted for inflation

In 2024, this adjustment amounts to a 5.4% increase in tax bracket thresholds and standard deductions. The top tax bracket will start at $731,200 for those with a status of “Married Filing Jointly,” up from $693,750 in 2023. The lowest tax bracket has a ceiling of $23,200 instead of $22,000. The same increases apply to certain other filing statuses, but it’s important to note that not all parts of the tax code receive these adjustments. Additionally, these adjustments only directly impact federal taxes, not state and local ones. In fact, the federal deductions for state and local taxes themselves are not adjusted for inflation.

Technically, the IRS uses what is known as the “Chained CPI For All Urban Consumers” (C-CPI-U) for these adjustments. CPI-U differs from the typically quoted CPI numbers by better accounting for changes in consumer spending patterns – particularly the so-called “substitution effect” – making it arguably more accurate over time. That said, CPI-U has also historically been lower than traditional CPI measures, potentially lowering the benefits taxpayers receive from inflation adjustments in the tax code.

Consumers expect higher inflation

While inflation has moderated significantly over the past year, recent economic data also suggest that consumers expect inflation rates to remain higher for longer. The latest data from the Surveys of Consumers by the University of Michigan show that consumers expect inflation to average 4.4% over the next year, an increase over the last two months from 3.2%. Consumers also expect inflation to average 3.2% over the next five years, a jump from the 2.8% in September and well above the 2% target the Fed hopes to achieve by 2026. While such short-term fluctuations in expectations may be the result of factors such as swinging energy prices and interest rates, they also reflect the uncertainty all consumers face in this economic environment.

Ironically, this tax and inflation discussion comes at a time when the government is facing difficulty agreeing on a budget. Congress should have originally agreed to a new budget this past September. Instead, it enacted a short-term funding plan, and subsequently repeated the process to kick the can down the road until early 2024. Unfortunately, as a result, we still do not have clarity about what to expect regarding federal funding levels for 2024 and beyond.

To some extent at least, such short-term machinations are largely irrelevant to investors and taxpayers because these political challenges stem from underlying and more permanent fiscal issues, namely the size of the federal deficit and debt. Unfortunately, these are challenges that are only likely to worsen. Many economists and investors worry that unless there are dramatic cuts to spending, the most likely direction of taxes is up. This is compounded by the fact that current federal tax rates are relatively low by historical standards.

The Social Security cost-of-living adjustment is 3.2% for 2024

On the bright side, just like the tax bracket thresholds, there are also inflation adjustments to Social Security benefits. These Cost-of-Living Adjustments (COLA) help Social Security recipients by raising benefits as prices of goods and services rise. The adjustment for 2024 will be 3.2%. Though this represents a deceleration from the 2023 increase of 8.7 due to slowing inflation rates, it is still noticeably higher than in much of the recent past.

Thus, inflation has many different effects on personal finances, including those on taxes and retirement benefits. And while inflation adjustments may help prevent additional tax burdens this year, the future path of tax policy remains uncertain and is likely to be challenging going forward.

If you are wondering what you can do before the end of 2023 to minimize the taxes you pay – as well as how you might best structure your finances to minimize your taxes over time – feel free to contact your Griffin Black Wealth Advisor. We’re here to help.

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