Inflation Part 2: How Inflation Will Affect Your Tax Bill

Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m sharing how the recent spike in inflation might affect your tax bill.

For the links and resources mentioned today, head over to youstaywealthy.com/144.

First, just a quick personal update that my family and I are FINALLY back in our home after moving to five different houses over the last 9 weeks with three kids and a dog. While we did make the best of it and, thanks to insurance, stayed in some very nice rentals along the way, it feels good to get settled back into our home.

If you’re a new listener, you can hear more about our house flood and some of the insurance lessons learned by checking out episode #137, the very last episode that aired in 2021. But, in short, aside from our insurance adjuster appearing to have WAY too many claims on his plate and customer service suffering a bit, I couldn’t be happier with how they handled our situation.

Also, just about all of the Stay Wealthy sweatshirts have been mailed out and I’m loving the messages I’m receiving from everyone.

Stuart Y. said it’s VERY high quality, just like this show. Much appreciated, Stuart.

Glenda P. said she LOVES it and it’s keeping her warm on her daily runs. You’re awesome, Glenda. Thank you.

Charlie O. is thankful that he has something to keep him warm for the last few days of winter out in Las Vegas, Nevada.

And Libby W. didn’t quite believe me when I said it was a high-quality sweatshirt and not just another cheap freebie giveaway, but confessed that she’s now worn it three days in a row and even got a compliment from her husband. Thanks for the honesty, Libby, really glad you AND your husband are enjoying it.

Thank you to everyone one more time for supporting and engaging with the show. This giveaway was just a small token of my appreciation and something I wanted to do as a thank you over the holidays. While I wish I could have given everyone a sweatshirt, I’ll definitely provide more opportunities for Stay Wealthy gear in the future. So, stay tuned.

Ok, let’s get into inflation…part 2.

And in case you missed it, between today and last week's episode airing, we already saw another jump in inflation. This time, inflation jumped 7.5% year over year.

As a reminder, these CPI reports come out monthly, however, the big inflation number they are reporting (and the media is recirculating) – the 7.5% number – is the year-over-year percentage change as of the most recent month's end.

For example, since we just wrapped up the month of January here in 2022, the report that just came out on February 10th is measuring and reporting the 12-month percent change of inflation from January 2021 to January 2022.

In last week's episode, I shared that inflation had jumped 7%, which was reporting the 12-month percent change from Dec 2020 to December 2021.

And this does bring up an interesting point, which is that it often makes more sense to pay closer attention to the month-by-month percent changes in inflation instead of the year over year, especially right now as we are coming out of a unique time period where the world shut down and consumer demand fell off a cliff and then came roaring back in a short period of time.

By looking at the monthly numbers, you’ll be able to better see if inflation is accelerating or decelerating.

https://www.bls.gov/news.release/pdf/cpi.pdf

For example, in October of last year, the one-month percent change in that month alone was almost 1%. In other words, prices jumped 1% in a single month due to an increase in consumer demand. But then we saw things cool down in November when the one-month percent change dropped to .7%, and then to .6% in Nov, .6% in December, and .6% again in January.

So, someone analyzing the month-by-month percent changes in inflation might conclude that the rate of change is actually decelerating or flattening. Which tells a very different story than the trailing 12-month inflation number which, again, is 7.5% for the 12-month time period ending January 31, 2022.

If you compared the 7% number that I referenced last week to the 7.5% number reported today, you might think inflation is accelerating…which I’d argue just isn’t true. If you look at the month-by-month changes you’ll see that it’s actually decelerated since October of last year and has now started to flatten.

Unless there’s a major unexpected event around the corner, I expect this trend to continue, which means, in a few months, the trailing 12-month percent change number you see in the news will likely begin to drop as it reflects that decelerating trend and some of the extreme price increases we saw in 2021 begin to fall out of the 12 month period we’re measuring.

I wouldn’t be surprised to see 12-month inflation reports to drop to the 4-5% range come summertime, and when and if that occurs, it will be interesting to see how the media begins to change their narrative on us.

So, once again, be careful with those news headlines and the conclusion they’re leading you to or you’re drawing from them. We have to look under the hood, dig a little deeper, and read the fine print, especially during times of uncertainty.

And for the record, I’m not suggesting that inflation is just going to disappear and it’s nothing to worry about. I’m just saying that the spike in inflation we saw as a result of the global pandemic and the corresponding supply/demand challenges we experienced (and are experiencing) as a result will begin to normalize the 12-month inflation numbers. We could very well begin seeing a longer-term trend towards higher prices for reasons outside of the pandemic-related supply/demand issues.

Given that this has been a hot topic, and one that has been very well received by all of our listeners, I’ll continue to revisit it on a periodic basis. Because even normal inflationary environments pose a threat to your retirement if not planned for properly.

And speaking of not planning properly, one overlooked result of the recent spike in inflation and consumer prices is how it might impact your tax bill. Because the higher inflation is, the more uneven its impact will be on taxes owed by retirement savers to the IRS.

As the wall street journal recently pointed out, inflation indexing began in 1981, after a long period of high inflation in the 70s as discussed in last week's episode. And that’s because, while wages increased with inflation during that time, tax brackets did not…they were fixed. As a result, Congress began indexing the income-tax brackets and a few other provisions for inflation.

But not everything has received inflation adjustments through all of this. For example, your mortgage interest deduction is capped on total mortgage debt at $750,000 across two homes.

So, if your total mortgage debt is $800,000, the interest paid on that $50,000 above the cap is not deductible, unless you’re grandfathered into the previous cap of $1 million before the change in 2017. So, not only has this cap not been adjusted for inflation but it’s been adjusted downward, causing an increase in taxes for those with larger mortgages in high-cost housing markets.

Another example of a provision that hasn’t been adjusted for inflation is capital gains exemption when selling your home. The exemption was enacted in 1997 and is currently $250,000 for single filers and $500,000 for married couples.

In other words, if you’re single and bought your home for $500,000 and sold it for $750,000, the $250,000 profit (or gain) from that sale would be exempt from capital gains taxes so long as it meets the other basic criteria which you can quickly look up if interested. If you’re married, you have $500,000 of gains that are exempt before you start paying taxes. Nice little benefit, but again, it was enacted in 1997.

If this exemption was adjusted for inflation, it would be just over $400,000 for single filers and just over $800,000 for married couples. This lack of inflation adjustment coupled with skyrocketing real estate prices and record-low mortgage rates means that those selling their highly appreciated homes are going to get hit with a higher tax bill due to inflation. You might be wondering why this exemption hasn’t changed.

Well, Leonard Burman, co-founder of the Tax policy center, summed it up pretty well by stating that,

“the intent was for the exemption level to decline in value over time due to inflation.

Basically, it’s a way of phasing in a tax increase or at least limiting the revenue costs.

Another provision that hasn’t been adjusted is the 3.8% surcharge on investment income put in place by President Obama. This surcharge kicks in when your modified adjusted gross income crosses $200k for single filers and $250k for married filing jointly.

These thresholds have not been adjusted for inflation, as a result, high earners basically get hit with a hidden tax hike every year. Not all that different from the capital gains exemption when selling your home. The lack of an inflation adjustment is a way to phase in a tax increase over time little by little.

On a more positive note, many of you in the working world will likely see an increase in pay in 2022. And that’s because the inflation factor used to adjust federal tax withholding tables has increased about 3% for 2022 due to inflation indexing, which is much higher than last year’s 1% increase. This adjustment increases your take-home pay and reduces the amount of taxes withheld from your paycheck.

For what it’s worth, the inflation adjustment of 3% still might seem low and that’s because a new method for calculating inflation adjustments in 2017 resulted in a slower-moving measure of inflation. Also, the IRS uses inflation numbers ending August 31st for the upcoming year’s tax tables, so given that inflation spiked during the second half of last year, the adjustment we’re seeing for 2022 excludes that jump in inflation.

According to federal tax analyst, Mark Luscombe, a super simple joint tax filer with $200,000 of pay, and no dependents, could see a bi-weekly increase of about $28.

Next, in addition to a bump in pay, those who are contributing to retirement accounts like IRAs and 401ks will benefit from the recent inflation adjustments as well. And that’s because the new method for calculating inflation adjustments in 2017 that resulted in a slower-moving measure of inflation was not applied to retirement account contribution limits.

In turn, retirement savers under 50 can contribute a maximum of $20,500 to a 401(k) here in 2022. If you’re over age 50, you can contribute up to $27,000. That change to the limit is just over a 5% increase from last year.

In other words, you can contribute 5% more to a 401k (i.e. a tax-advantaged account) this year than last year. So, thanks to inflation you’re able to save more money for retirement and benefit from a reduction in taxes. Unfortunately, there was no increase to traditional or roth ira increases this year as they need to be made in $1,000 increments.

Lastly, social security recipients are likely already aware that their benefits are getting a nice 5.9% boost this year, the highest increase in 40 yrs. However, a higher benefit also means a higher tax bill, and that’s because the income thresholds for social security payments aren’t inflation adjusted.

Those thresholds have been sitting at $44,000 for married couples filing jointly and $34,000 for individuals since 1994. If they were adjusted for inflation, the thresholds would be closer to $80,000 and $62,000, respectively.

Karen Smith at the Urban Institute shared that roughly 64 million adults will receive social security benefits this year. And for about half of those recipients, their payments will be taxable. On the other hand, if those thresholds were adjusted for inflation, only about 24 million social security recipients would have taxable payments.

Of course, and it likely goes without saying here, but medicare premiums have also increased this year as they always do. So, while the bump in social security payments appears nice, it results in a higher tax bill for a good chunk of Americans and that increase is also partly offset by an increase in Medicare premiums.

To recap and summarize the 6 ways inflation might impact your taxes in 2022:

1. The total mortgage interest deduction cap remains unchanged at $750,000, resulting in a higher tax bill for those in high-cost housing markets who weren’t grandfathered into the prior $1 mil caps.

2. Capital gains exemption when selling your home also remains unchanged, while at the same time, real estate has skyrocketed. In short, if you’re in a high-cost housing market and you sell your home this year, expect a higher tax bill.

3. The 3.8% surcharge on investment income put in place by President Obama remains unadjusted for inflation, resulting in higher tax bills for high earners.

4. Working professionals will likely see a bump in pay this year because the inflation factor used to adjust federal tax withholding tables has increased about 3% for 2022

5. Those contributing to 401k’s can save about 5% more to their tax-advantaged retirement accounts this year, resulting in more money for retirement and a lower tax bill

6. Social security recipients received a nice bump in benefits this year, but it also results in more of those payments becoming taxable given that the income thresholds aren’t inflation adjusted. Also, the increase in medicare premiums offsets some of that bump in income.

The point of today’s episode was not to drag you down and highlight all the negative tax impacts of inflation. The point was simply to point out that inflation affects more than just the price of consumer goods and services and to point out the importance of proactive tax planning.

It’s important to understand how your tax bill will change year over year so you can take appropriate action to plan ahead. The last thing anyone wants is to get caught off guard with a larger-than-anticipated tax bill.

Most CPAs, and high-quality financial planning firms, can run tax projections for you and it’s an exercise that everyone should go through at least once a year. It’s been years since I’ve used the DIY tax prep tools like turbo tax, but my guess is you can run your own tax projections there as well if you don’t work with a CPA or financial planner.

For all the links and resources mentioned today, head over to youstaywealthy.com/144.

Thank you as always for listening and I’ll see you back here next week.

Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.