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TaxWatch: Yes, inflation does affect your tax return. Here are 5 things to watch out for.

As Americans complete their income-tax returns ahead of the April 18 deadline, they are revisiting the effects of last year’s inflation — even if they don't realize it. Read More...

As Americans complete their income-tax returns ahead of the April 18 filing deadline, they are revisiting the effects of last year’s scorching-hot inflation — even if they don’t realize it.

Like so much else in a person’s financial life, inflation seeps into their tax situation.

When the tax code attempts to account for rising prices, particular provisions get pushed higher. That includes the standard deduction and tax brackets, which are some of the approximately 60 provisions the IRS updates annually for inflation. But when the tax code is tethered to specific money amounts that go unchanged, the effects can become glaring over time.

Broadly speaking, the tax code does a passable job of responding to inflation, said Mark Steber, senior vice president and chief tax information officer at the national tax preparer chain Jackson Hewitt. “It’s good on the surface and it’s good under the surface. But it’s not good for every taxpayer,” he said. It depends on an individual’s financial events and on how the tax code treats those events.

So far, federal income-tax refunds for 2022 are averaging $2,910, which the IRS says is almost 10% lower than last year. That’s due at least in part to the end of pandemic-era boosts to certain tax credits, experts have said.

But it’s a bad time for refunds to be lower. Although inflation is inching lower, consumers still aren’t breathing easy, and there are still signs of financial pressure, like rising credit-card debt and the popularity of buy now, pay later platforms for necessities like groceries.

Wednesday offered the latest numbers on the slow retreat from four-decade high inflation rates. In March, the cost of living increased 0.1% from February — and prices increased 2.4% for tax preparation fees. Meanwhile, March’s year-over-year rate of inflation was 5%, down from 6% in February.

Here’s a look at some of the easy-to-spot — and less easy-to-spot — ways that inflation is affecting tax returns.

Tax brackets

Every year, the IRS readjusts its income-tax brackets in an effort to avoid “bracket creep.” If someone’s getting paid slightly more to keep up with inflation but the tax brackets aren’t nudged higher, that person will hit the higher tax bracket sooner without the real income to show for it.

Adjusting tax-brackets for inflation goes back to the Reagan administration, when the country was emerging from a long period of inflation.

For tax year 2022, the seven brackets increased by 3%. For tax year 2023, they have increased by 7%. The IRS arrives at the bracket calculations using the “chained consumer-price index,” an inflation gauge that uses different methodology than the regular CPI.

See also: What are tax brackets for 2022 — and why do they increase over time?

It might be hard to detect major changes in your tax bill if your wages rise with inflation. If your wages don’t rise but inflation-indexed brackets do, on the other hand, that could be noticeable, Steber said.

“If you’re standing still and you didn’t make any more money, you’re probably going to owe less,” he said. And while minimizing taxes sounds appealing, consider the implication of a stagnant income during a time of high costs. “You owe less tax, but are you in a better economic situation? Probably not,” Steber said.

The standard deduction

The standard deduction is also indexed for inflation using the chained CPI to determine how steep the increase is each year. The standard deduction is a widely used way to reduce taxable income, versus itemizing deductions. Approximately 90% of households last filing season took the standard deduction, according to IRS data.

Retirement savings

The annual caps on 401(k) and IRA contributions also increase over time. In addition to helping people save for retirement, the contributions are a way to reduce taxable income. For tax year 2023, the maximum 401(k) contribution limit for workers under age 50 will be $22,500, up from $20,500 for 2022 and from the $19,500 level for 2021 and 2020. The limit for catch-up contributions for workers age 50 and over also increased for 2023, to $7,500.

Inflation affects where those contribution levels are set, noted Rita Assaf, vice president of retirement products at Fidelity Investments. The amounts are informed by a cost-of-living adjustment similar to Social Security’s adjustment, Assaf said.

“Unlike Social Security, contribution limits for retirement plans only increase when the cost-of-living-adjustment is in excess of a certain amount and therefore [it] may not change each year,” she added.

Starting in tax year 2024, the limit for catch-up IRA contributions for workers age 50 and over will also be indexed for inflation, Assaf noted. That’s because of provisions in SECURE 2.0, the retirement-savings legislation that Congress passed in a wide-ranging end-of-year bill. For now, the catch-up limit is $1,000. Assaf noted, however, that the limit will “only increase if the cost-of-living adjustment calculation is in excess of $100.”

Tax provisions can help you plan for retirement in the face of inflation, but the key part is investing for the future. “A well-diversified retirement-savings portfolio may help to offset some of the negative impacts of inflation,” she noted.

Capital gains

Capital losses first offset capital gains when the IRS tallies an investor’s tax bill. If losses exceed gains, the taxpayer can deduct up to $3,000 and the excess losses are carried forward to future tax years. The capital-loss limitation has been at this threshold since 1978.

It’s a badly outdated part of the tax code that’s a disincentive to investing, according to U.S. Rep. Ralph Norman, a Republican from South Carolina. Last year, he introduced a bill that would raise the capital-loss limitation to $13,000 and index it to inflation going forward.

“This is a well overdue, small modernization of the tax code that I believe will have a big impact restoring investor confidence in these uncertain times,” Norman said in a statement when introducing the bill.

Another part of capital-gains taxation also hasn’t changed: The capital-gains exclusion for people selling their home is $250,000 for single filers and $500,000 for married couples filing jointly. It’s been that way since Congress created the exclusion in 1997, according to the Tax Foundation, a right-leaning tax think tank. Juxtapose that with how much home prices have appreciated in recent years — and especially during the pandemic.

Inflation-relief checks

Some forms of government assistance to a household are considered taxable income. For example, jobless benefits generally have to be included as income, the IRS notes.

But what about the array of checks that states sent to residents in 2022 with the aim of helping cover increasing everyday costs? Due to the way that 17 of 21 states’ payments were structured, recipients in those states — California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Maine, New Jersey, New Mexico, New York, Oregon, Pennsylvania and Rhode Island — didn’t need to report the money on their return, the IRS said in early February. The same goes for Alaska’s extra payment tied to energy costs.

Most people in Georgia, Massachusetts, South Carolina and Virginia also don’t have to include the payments on their returns, experts said. Without getting deep into the tax technicals, people in those states don’t have to include the payments if they took the standard deduction — which the vast majority of people do.

The IRS made that announcement one week after telling tax filers to briefly hold off on submitting their returns while the agency determined the tax treatment of the payments — a move that prompted some criticism that the IRS should have resolved the issue ahead of filing season.

For early filers who reported the state payments on returns submitted before the Feb. 10 announcement, the IRS recently advised them to consider filing an amended return.

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