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Outside the Box: 8 unexpected ways inflation can lead to higher taxes

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Inflation has been the big economic story of 2022. Steep increases in consumer prices have hurt families in many ways—some of which aren’t so obvious.

You’re likely aware of the hefty increases in borrowing costs, home prices, rents, gas prices and groceries. But here’s something else to consider: how inflation can lead to higher taxes.

Important parts of the federal tax code aren’t indexed for inflation. Result: If inflation leads to nominal increases in a family’s income, it could lead to larger tax bills at a time when many taxpayers are already contending with steeply higher consumer prices. That would be an ill-timed double whammy for many Americans. Consider eight examples:

Social Security benefits are taxed once a retiree’s “combined income” crosses certain thresholds, set at $25,000 for single taxpayers and $32,000 for married couples. Benefits are adjusted each year for inflation, but these thresholds aren’t. Depending on your benefit level, a larger chunk of your Social Security check could be lost to taxes.

High-income taxpayers often face the Medicare surtax. This surtax hits not only earned income, but also investment gains. The net investment income tax is an additional 3.8% tax levied on dividends, interest and capital gains. The Medicare surtax applies if your modified adjusted gross income exceeds $200,000 for single taxpayers and $250,000 for couples. These thresholds aren’t indexed for inflation. If inflation leads to an increase in your income, you might find yourself above the threshold level.

Inflation boosts both the interest income from inflation-indexed Treasury bonds and the principal value of these bonds. That’s the good news. The downside: These gains are taxed as ordinary income in the year they occur, unless you hold the bonds in a retirement account. That means high inflation will mean more taxable income for holders of inflation-indexed Treasurys, resulting in higher taxes. This is true even though bondholders don’t receive the inflation-adjusted principal value until they sell or their bonds mature.

Housing prices have soared over the past year, which might expose homeowners to unexpected capital-gains taxes when they sell. In a recent article, I described the capital gains exclusion for the sale of a primary residence. A single filer can exclude up to $250,000 in capital gains on a home sale without paying taxes. A married couple can exclude $500,000. These amounts haven’t changed since 1997.

Unlike housing prices, stocks most certainly haven’t soared in 2022. Still, if stocks prove to be the long-term inflation hedge that they’ve historically been, investors may find themselves paying capital-gains taxes on large nominal gains—but modest after-inflation returns.

The child tax credit reduces the tax burden on families with children under age 17, but inflation could make the credit less effective. The maximum credit is $2,000 per child from 2022 to 2025. Inflation reduces the purchasing power of every dollar, so higher inflation will cause the real value of the credit to shrink.

Paying college costs? The income thresholds to qualify for both the American Opportunity Tax Credit and the Lifetime Learning Credit don’t adjust for inflation, which means some families will find they can no longer use these credits simply because their employer gave them a cost-of-living pay increase. What if you do qualify? Like the child tax credit, these education credits are now worth less in inflation-adjusted terms.

Many states don’t index their income-tax brackets for inflation. Of the 41 states that tax wages, 15 of them, plus Washington, D.C., do not automatically adjust their tax brackets for inflation. That means rising nominal wages could push taxpayers into higher brackets at the state level.

What can be done? John Goodman and Boston University professor Laurence Kotlikoff recently proposed several measures to reduce the tax bite caused by inflation. For instance, they recommended fully indexing the federal tax code for inflation and doing the same for the threshold at which Social Security benefits are taxed. They also proposed eliminating the payroll tax for anyone over Social Security’s full retirement age.

This column first appeared on Humble Dollar. It has been republished with permission.Richard Connor is a semiretired aerospace engineer with an interest in finance and a contributor to Humble Dollar. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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