For early and mid-career professionals, meeting your financial goals has faced significant headwinds. Inflation has been making every area of our lives more expensive as the costs of daily goods and services have soared. The central bank, or the Federal Reserve, is attempting to lower inflation by using the bluntest tool in monetary policy – raising the key short-term interest rate (properly known as the Fed Funds Rate).
However, inflation has remained stubborn, and higher costs for debt are following. You've likely noticed the difference if you carry a credit card balance. And hopefully, if you are a homeowner and have a mortgage, you have a fixed-rate mortgage. Because if you have a fixed mortgage, your total housing costs likely have not increased as much as renters or those with variable-rate mortgages.
But there may be a small silver lining to all this crazy inflation. The IRS pegs specific tax regimes such as tax brackets, tax deductions, 401(k), and other tax-efficient vehicle contribution amounts to inflation. A careful review of your financial picture, combined with some proactive tax planning, may save you money and set you up for increased savings in the years to come.
Tax Brackets Are Increasing
Tax brackets are increased due to inflation to ensure that tax brackets reflect people's real income. Inflation means credits, deductions, and exemptions are worth less if there is no adjustment, which results in increased taxes. Raising the amount of the income range in each bracket shelters more income from higher rates.
The increase is usually so slight that it doesn't affect most people's tax brackets, but this year the brackets jumped a lot. You can see the change for yourself. The chart below illustrates the difference between the 2022 and 2023 income tax brackets.
The Standard Deduction Is Also Increasing
Filing your taxes may also have gotten simpler. The standard deduction – the amount you are entitled to claim without itemizing – increased to $13,850 for single files in 2023. For married couples filing jointly, the new deduction amount is $27,700. For the 2022 year, the standard deduction is $12,950 for single filers and $25,900 for those filing married filing jointly. If you don't usually itemize, this is probably good news. However, suppose you typically itemize your deductions. In that case, you may find that some of your regular deductions, such as gifts to charity, are no longer tax benefits because it would be better for you just to take the standard deduction.
One solution to this problem is to cluster your charitable gifts. "Clustering" refers to grouping donations intended for several years into a single year. This strategy is only effective if all your itemized deductions, including the clustered gifts, are more than the standard deduction. And also, keep in mind you should first want and be able to provide such gifts to use this as a tax strategy.
The Impact on Retirement and Healthcare Savings Limits
Retirement savings contributions are getting a boost of almost 10% in 2023. The new maximum employee contribution limit for 401(k)s is $22,500. The "catch-up" limit for people over 50 also increased to $7,500. The new limits don't just mean increased savings; they also lower your taxable income if you contribute to a pre-tax 401(k) plan.
Flexible spending accounts (FSAs) got a $200 boost, allowing you to contribute $3,050 of pre-tax dollars to this type of account to pay for medical costs that aren't covered by insurance. However, with most FSA, there is a spend it or lose it provision. So be sure to contribute if it makes sense for your needs.
Health Savings Accounts (HSAs) have new annual maximum contributions, too. An individual can contribute up to $3,850, and the family contribution has risen to $7,750. HSAs are referred to as "triple-tax-advantaged" because you contribute pre-tax dollars that lower your taxable income in the year you contribute, the accounts grow tax-free, and qualified withdrawals are also not taxed. And these accounts are portable, a significant advantage over FSAs. But be mindful that you must be covered by an HSA-eligible health insurance policy to contribute to an HSA.
It's Not All Good News
Social security benefits also increased, which may be good news for retirees. However, if you're still working, you're still paying into the system. Social security taxes are 6.2% of income, up to a maximum earnings ceiling. The limit increased by almost 9%, to $160,200 in 2023, from $147,000. This translates to a dollar amount of $9,932, up from $9,114 in 2022.
Additionally, not all aspects of the tax code are linked to inflation. The following items will not change for 2023:
The child tax credit will remain at $2,000, with income phaseouts staying at $200,000 for single filers and $400,000 for those filing married jointly.
The annual deduction for capital losses will remain at $3,000.
And the state and local tax (SALT) deduction will remain at $10,000.
The Takeaway
Elevated inflation is likely to be with us for a while longer. The Fed is working to dampen the economy to bring prices down, but a robust labor market and ongoing – although lessening – supply chain issues are pushing the other way. Taking advantage of the silver lining of inflation by maximizing tax-advantaged savings, and undertaking proactive tax-planning strategies, can help you keep your financial planning on track.
I work with early and mid-career individuals. If you are navigating your finances and trying to understand how changes in tax rules can enable you to achieve your goals, feel free to place a complimentary 30-minute meeting on my calendar. In that meeting, we can discuss your objectives and situation.
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