If your income hasn't kept pace with inflation this year, you may soon get some financial relief in the form of a tax cut.
The Internal Revenue Service (IRS) has released adjustments to tax brackets for 2023, adding thousands of dollars to most marginal tax brackets, and potentially protecting more of your income from taxes next year. The 7.1% adjustment is one of the biggest in decades, and more than twice what it was in 2022.
Additionally, the standard deduction will rise. For married couples the bump up is $1,800 to $27,700. For single filers, it's an increase of $900 to $13,850. The adjustment reflects record inflation of 8.2% through September 2022, and if your income didn't quite keep up with the runaway price increases on everyday items from gas to groceries, the good news is you may find yourself with a bit more money when it comes time to settle your tax bill.
Why do tax brackets change?
The US has a progressive tax system, meaning as someone's income rises, it's taxed at a gradually increasing rate corresponding to 7 brackets, which rise like a set of steps. Every year the IRS announces changes to the tax brackets. Those changes are pegged to inflation, and the adjustments occur at roughly the same time the federal government makes changes to Social Security payments through the cost-of-living adjustment (COLA).
How the 2023 tax brackets might affect you
Here's how the changes might play out for an individual filer who earns $100,000 both in 2022 and 2023, and who takes the standard deduction in both years.
The $508 in savings is the result of the higher standard deduction, as well as a lower effective tax rate (the total percentage of income that is taxed.) As brackets widen, more of your taxable income is taxed at a lower rate.
While the changes affect everyone, they particularly have an impact on people whose income did not keep pace with inflation this year. Real weekly earnings decreased on average by 4% from September 2021 through September 2022, according to the US Department of Labor.
Tactics to help manage tax bracket changes
There are 2 ways you can take deductions on your federal income tax return: You can itemize deductions or use the standard deduction. The standard deduction is a dollar amount preset by the IRS. Itemizing means adding up all the deductions you may qualify for, up to a certain limit that could be higher than the standard deduction.
- The higher standard deduction and the new tax brackets next year mean it may be better for more people to take the standard deduction. For example, if you itemized last year and your itemizations this year will be less than the higher $27,700 standard deduction for married couples, or $13,850 for single people, switching to the standard deduction could make sense.
- If you're close to the standard deduction cutoff, additional charitable contributions could make itemizing more worthwhile. If that's the case, and donating to charity is one of your goals, you could also consider a "bunching" strategy for 2023. That essentially entails combining all your charitable deductions for several years in a single year, enabling you to exceed the standard deduction next year, and potentially dropping you into a lower tax bracket. The following year, while you wouldn't claim charitable deductions, you'd still qualify for the standard deduction, which could save you thousands of dollars in taxes over 2 tax years.
- Finally, if you've been thinking about a Roth conversion, next year might be a good time to do one. The new tax rates, combined with the recent drop in stock prices, may mean the money you convert from a traditional IRA to a Roth could be taxed at a lower rate. A conversion for tax year 2023 might be particularly helpful for people who expect their tax rate to be higher in future years.
Important to know
An opportunity to save more in a 401(k)
In addition to tax savings, the IRS made adjustments to numerous other parts of the tax code that have an impact on retirement saving and more.
People who have access to a 401(k) plan through work can consider putting more money away next year, as the IRS also announced annual contribution limit increases for 2023. Participants in such plans can contribute $22,500 (pretax), up from $20,500 in 2022. People 50 and older can make catch-up contributions of $7,500, an increase from $6,500 this year.
2023 IRA contribution limits
IRA contribution limits have also increased to $6,500 for 2023, compared to $6,000 for 2022. (Catch-up contributions did not change.)
Contributions to a traditional 401(k) or a traditional IRA can reduce your taxable income, and deferred amounts are not taxed until you begin withdrawals in retirement.
2023 HSA contribution limits
Lastly, the IRS also increased health savings account (HSA) annual contribution limits. The inflation adjustment lets individuals save $3,850, up from $3,650 in 2022. For family coverage, contribution limits for next year have jumped to $7,750 from $7,300. HSAs can help people save for rising health care costs now and in retirement.
All in all, the tax changes for 2023 should help offset some of the pain of rising inflation and help people save for retirement. To make the most of these changes as you plan for 2023 and beyond, consider working with a tax professional.