As we near the halfway mark in 2022, one of the most pressing topics on the minds of many Americans is the rise in inflation to levels we haven’t seen in decades. If you are under the age of 41, the inflation rate we are currently experiencing is the highest it’s been in your lifetime, and it likely will remain fairly high for the rest of the year.
Inflation is sometimes referred to as a “tax”, because just like an increase in actual taxes, it results in you keeping less of the money you earn. This is because you’ll need to spend more of your money on the necessities of life, such as food, housing, gas, etc. When people refer to the “inflation tax”, they are speaking figuratively, since inflation is not technically a tax.
However, there are three ways that inflation can increase the actual taxes you pay—as in, the money that you pay to the federal, state, and local governments. Let’s take a look at each of these, and what steps you can take to minimize or eliminate their impact.
Inflation and Tax Brackets
The first way that inflation can increase your actual taxes is if you live in a state where the income tax brackets are not indexed to inflation, as is the case in Virginia and 14 other states.
The general idea behind progressive income tax brackets is that people who earn more money will pay a higher tax rate than people who make less money. The problem with periods of high inflation is that even if people earn more money on paper, the buying power of their money does not actually go up. If they live in a state where income tax brackets are not automatically adjusted for inflation, this means that their tax rate would go up even though in real terms they are not earning more money.
For example, let’s consider the hypothetical situation of an individual who makes $50,000 a year in taxable income in Virginia, where all income over $17,000 is taxed at the rate of 5.75%. Let’s imagine this person got a raise and made $54,000 in taxable income in a year when inflation was 8%.
Essentially, their wages rose at the same rate as inflation, meaning that in real terms they are not any wealthier than they were before their raise. However, their state tax bill would still go up by $288, because they would pay the 5.75% tax rate on $38,000 worth of income instead of $33,000 worth of income.
The good news is that there are things you can do to reduce your taxable income through deductions, such as contributing to a retirement plan or donating money to charity. Consulting with a tax professional to do some year-end tax planning will help you determine how to best minimize the impact of inflation on your state taxes.
Inflation and Property Taxes
The second way that inflation can raise your taxes is by increasing the property taxes you owe to local government (county, city, town, etc.). The high demand that drives inflation not only increases prices of things you need or want to buy, but it also increases the value of things you already own, like your house and car.
According to the S&P/Case-Shiller Home Price Index (the leading measure of U.S. residential real estate prices), home prices rose on average by over 19% in the past year, and will likely rise by another 9% this year. The value of some categories of used cars, as measured by the consumer price index, rose as much as 40% in the past year.
In both the housing and automotive markets, the increase in price is being driven by more than just inflation—factors unique to those industries, such as a shortage of building materials and production delays, are causing prices to rise even faster than the overall inflation rate.
As a result, you can expect your property tax bill to go up (after your next assessment), even if the tax rates in your area did not increase. Your home insurance premiums may also increase since the replacement cost of your home may be higher due to higher construction costs. Some insurance policies may require you to buy additional coverage, whereas others may automatically adjust for inflation.
While there isn’t much you can do to avoid paying higher property taxes on your house, when it comes to your car, you could consider selling any vehicles you own that don’t get much use. Used car dealers are desperate for inventory, so you would get a great price for your car and use the money to help offset other inflation-related costs impacting your budget.
Inflation and Capital Gains Taxes
The third way inflation can affect the taxes you pay is when it comes to capital gains tax. This is the tax you pay on income you get from selling an asset, such as stocks, investment properties, etc. In this case, the “income” that is taxed is the difference between the value of the asset when you purchased it (your original or adjusted basis) and the value when you sell it (sales price).
When an asset is held for a long period of time and the value of the asset does not rise at a faster rate than inflation, the money received when you sell the asset would have the same, or less, purchasing power than the money you used to buy the asset—so, essentially, your rate of return on that investment would be zero in real-world terms, even though on paper you made a profit.
If you end up needing to pay capital gains tax on the profit (which is based on the type of asset, your tax bracket, and how long you have held the asset), this means that in real-world terms you could actually lose money on the investment.
This is true no matter what the inflation rate is, but in periods of high inflation like we have now, it makes it more likely that values of certain types of assets might rise at a lower rate than inflation.
The good news is that you probably have some control over when you sell your investments. If the current value of an investment is such that selling it now would not result in a profit after adjusting for inflation, it may make sense to continue to hold the asset if its value is likely to rise faster than the rate of inflation going forward.
As you can see, there are many ways that high inflation costs you money beyond just increasing the price of goods and services you buy. This is one of the many reasons it’s important to consult with a tax professional every year. A CPA can help you understand how the current economy impacts your individual finances, which will help you minimize your tax burden. Contact us today to take advantage of our tax planning services during this time of economic uncertainty.