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Inflation means the IRS could soon change your tax bracket. Here's what to know.

Inflation remains high even as gas prices drop
Inflation remains high even as gas prices drop 07:54

Every year, the IRS adjusts many provisions to account for the impact of inflation, ranging from individual tax brackets to how much you can save in your individual retirement account, or IRA. With inflation running near a 40-year high, experts say some major changes are likely to be in store for taxpayers. 

The IRS makes these changes to avoid "bracket creep" from the rising cost of living, noted American Enterprise Institute's Kyle Pomerleau, an expert on taxes. Without such adjustments, workers who received pay increases to keep up with inflation would be bumped into higher tax brackets, even though their standard of living remained the same. 

This year, taxpayers could see some of the biggest changes in decades due to the hottest inflation since the early 1980s, tax experts say. While the IRS will likely officially announce these changes in October or November, the tax agency relies on a formula, based on inflation data, for calculating the new tax brackets and other limits. Based on that formula, Pomerleau forecasts that many tax provisions will be adjusted upwards by about 7%. 

"This is something taxpayers can use to plan their taxes over the next year," Pomerleau noted. "So, next year taxpayers are going to set their withholding, businesses will make investment decisions, and that will depend on how much tax they have to pay."

Some taxpayers will be relying on the new inflation-adjusted provisions to make changes in the next several weeks, however. For instance, people who use flexible spending accounts to put aside money for medical expenses will need to make those decisions for 2023 in October or November of this year during open enrollment.

Taxpayers will also likely see a higher standard deduction in 2023, which could help lower their taxes. The standard deduction is an amount that taxpayers can use to reduce their taxable income, so a boost to this provision could conversely lower the amount of income earned by a worker that will be subject to tax next year.

Workers should also consider whether they should invest more in their IRA or 401(k) accounts, given that it's likely the IRS will also make the contribution limits more generous to reflect this year's inflation, noted Eric Bronnenkant, head of tax at financial firm Betterment. 

"The IRA threshold now is $6,000, so a lot of people have it set up so they put in $500 every month, and if they aren't thinking about it and here's an increase and they don't adjust upward, they could be missing out on a retirement plan benefit," he noted. 

New tax brackets for 2023

Tax brackets determine the tax rate you'll pay on each portion of your income. 

For instance, take a single worker whose taxable income this year is $40,000. They'll pay 10% of tax on the first $10,275, and then 12% on their earnings between $10,276 and $40,000.

In 2023, when Pomerleau estimates that tax provisions will move up about 7% per bracket, that same worker would pay taxes of 10% on the first $11,000 of their earnings, and then 12% tax beyond that.

Higher limits for FSAs, IRAs

The IRS is also likely to boost the limits for flexible spending accounts (FSA) and IRA contribution limits, Pomerleau said. 

According to his calculations, the new limit for flexible spending accounts will be $3,050, or an increase of 7% from the current year's top threshold of $2,850. 

FSAs allow workers to put up to that limit in an account that can be used to pay for medical expenses. Because the money is taken from their accounts on a pre-tax basis, it offers tax savings for many workers. 

The new IRA limit is likely to be $6,500 for 2023, Pomerleau said. That's an increase of about 8% from the 2022 limit of $6,000. 

"This is likely to be the one time you'll see a bump this large," Pomerleau said of his forecasts. "If inflation starts tapering off, which I think that will occur, we'll go back to more modest annual adjustments each and every year. This may end up being a one-time thing."

Higher standard deduction

The standard deduction is also likely to be increased, Pomerleau said. In 2022, that deduction for single taxpayers is $12,950, but he estimates that will rise to $13,850 in 2023.

Married couples who file joint tax returns have a 2022 standard deduction of $25,900, but that could increase to $27,700 next year. Meanwhile, head-of-household filers could see their standard deduction rise from $19,400 this year to around $20,800 in 2023, Pomerleau said. 

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