If your wages have risen this year along with inflation, that's good news. But along with the additional cash, it's possible you may be in for an unpleasant tax surprise too.
Although wage increases may have helped your income keep pace with rising costs for everything from food to housing and auto repairs, a bigger paycheck may also bump you into a higher marginal tax bracket, in a phenomenon called tax-bracket creep.
Tax-bracket creep happens during periods of high inflation when wages rise, pushing people into higher tax brackets. It can result in a double hit to your wallet as the rising cost of many common consumer items crimps budgets, while your extra pay could potentially increase your tax bill.
While the federal government adjusts marginal tax brackets for inflation each year, it does not make adjustments to numerous credits, deductions, exemptions, and surcharges, which can mean your effective tax rate could go up, whether you take the standard deduction or itemize.
For example, the net investment income tax (NIIT) on capital gains, dividends, and interest income has not been adjusted since it was enacted in 2013. It's an added 3.8% surtax on everything from home sales to interest paid on CDs and taxable bonds if those things push your income past $200,000 for a single person and $250,000 for married couples. The NIIT is particularly worth paying attention to as house prices continue to rise and as interest rates have pushed yields up for both bonds and CDs.
Here are 8 steps to consider now to help you reduce your tax bill and reduce tax-bracket creep.
1. Maximize retirement contributions
Fortunately, you can reduce your taxable income dollar-for-dollar with yearly contributions to your 401(k), IRA, and other retirement accounts.
People who have access to a workplace retirement plan can contribute up to the maximum of $22,500 for 2023 (up from $20,500 in 2022). People age 50 and older can make catch-up contributions of $7,500, an increase from $6,500 in 2022.
Contribution limits to IRA plans have also increased to $6,500 for 2023, compared to $6,000 for 2022. (Catch-up contributions did not change.)
2. Remember your health savings account (HSA)
If you're eligible to contribute to an HSA because you have a high-deductible health plan, contribution limits are now $3,850 for individuals and $7,750 for families for 2023, with $1,000 more in catch-up contributions for those over 55. That's up from $3,650 for individuals and $7,300 for family coverage in 2022, with no changes to the catch-up contribution for individuals 55 and older.
3. Defer payouts and payments
If you sold a house, collected severance from a job after a layoff, or sold anything of value where you expect a taxable gain, it's worth considering whether you can collect the money the following year if the additional income pushes you into a higher tax bracket, or you expect to be in a lower tax bracket the following year. Similarly, if you plan to sell stock that has increased in value, you could think about splitting the sale over 2 years if the full amount will push you into another tax bracket, or subject you to the NIIT surtax. Relatedly, if you've done contract work in addition to your regular job to make ends meet, you might consider delaying payment until the following tax year if the extra income will push you into a higher tax bracket.
4. Make the best use of a Roth conversion
While Roth conversions from a traditional IRA are fully taxable, you aren't required to take money out of a Roth once the funds are in the account. After that, payouts aren't subject to taxes when you do withdraw funds, assuming you've met all conditions for the account, including the 5-year aging rule and are 59½ years old or older. Additionally, a conversion may reduce the value of the traditional IRA from which the funds were transferred, which could in turn lower required minimum distributions (RMDs) from the traditional account.
5. Tax-loss harvesting
You might also want to consider year-round tax-loss harvesting where you use realized losses to offset gains elsewhere, plus up to $3,000 of ordinary income depending on filing status. If you've got investments that are below their cost basis, and there's another investment that's similar (but not a substantially identical security), you could use it to replace the sold asset without a material impact to your investment plan. Consult your tax advisor about your situation and beware of the wash-sale rule.
6. Make full use of asset location
You're likely to have different types of accounts that can be aligned with specific financial goals. Some accounts, like brokerage accounts, are subject to taxes every year, while others (retirement accounts) can have tax advantages, such as tax-deferral or being tax-exempt (Roth accounts).1 At the same time, some types of investments—think bonds, bond funds, and high-turnover, actively managed stock mutual funds—can have bigger tax consequences. Consider putting the higher-tax investments in accounts with more favorable tax treatment, such as tax-deferral or tax-exemption.
Find out more about tax-smart asset location in Viewpoints: Are you invested in the right accounts?
7. Qualified charitable distributions (QCDs)
For individuals in retirement who have to take required minimum distributions, donating to charity can help reduce tax-bracket creep. You can make a QCD from an IRA of up to $100,000 per individual (or $200,000 total if you're married and filing jointly), as long as the charity receives your donation by December 31. The money you donate is not deductible, but it's not subject to federal taxes, qualifies as your RMD for the year, and you can make one even if you don't itemize. QCDs are also allowable starting at age 70½, so you don't have to wait until RMDs begin to take advantage of one.
8. Deductions for charitable contributions
If you have extra money to give this year, you might consider bunching, which involves concentrating charitable deductions in a single year, and skipping the following year, or even several years. The following year, you likely wouldn't claim charitable deductions, but you'd still qualify for the standard deduction. And if you put your contributions into a donor-advised fund, you can take the charitable deduction in 2023, but spread your giving out over many years. If you want to itemize, this strategy can help. Itemizers can also donate appreciated assets held longer than one year to a qualified public charity and deduct the fair market value of the asset without paying capital gains tax.
Similarly, itemizers can deduct cash contributions as well as property
—think the bookshelf you donate to your local school. Deducting charitable contributions may be subject to adjusted gross income (AGI) limits depending on the receiving charity and what you donated.2
The good news is inflation is showing signs of easing this year, and federal tax brackets (and the standard deduction) are likely to be adjusted upward again this fall to compensate for the higher cost of living. Nevertheless, it's still a smart idea to keep tax-reduction strategies in your back pocket to meet the potential burden of tax-bracket creep. As always, consult with your tax advisor or a financial professional to create a plan that works for you.