7 Ways Inflation Can Cost You at Tax Time

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Inflation leads to higher bills everywhere, from your favorite grocery store to the car dealership. It also can reduce the value of some key tax deductions and exemptions.

A handful of seemingly straightforward federal income tax breaks are not indexed for inflation, meaning they are not automatically adjusted every year or so — if ever — to keep pace with the rising cost of living.

So, these deductions and exemptions become less valuable — or become accessible to fewer people — over time.

Federal tax breaks that have been doomed to suffer this fate include the following.

1. Social Security income tax exemption

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It comes as a shock to many new retirees that their Social Security benefits are taxable. But Uncle Sam isn’t completely cold-hearted: He doesn’t tax 100% of retirement benefits.

Anywhere from 0% to 85% of a retiree’s Social Security benefits are subject to income tax. The exact rate depends on retirees’ tax-filing status and what the federal government refers to as their “combined income.”

For example, a retired couple who file a joint tax return and have between $32,000 and $44,000 in combined income would owe taxes on up to 50% of their Social Security benefits. Couples exceeding $44,000 would owe taxes on up to 85% of their benefits.

But these income thresholds are not adjusted for inflation. This is a big problem for millions of retirees. When Social Security benefits first were taxed in 1984, it was projected that 10% of recipients would owe taxes. However, because the thresholds were never indexed for inflation, we’ve arrived at the point where about 40% of those getting Social Security owe taxes on their benefits.

2. Mortgage interest deduction

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The mortgage interest deduction is not nearly as valuable as it was in the past. To be eligible for this tax break, you must itemize your deductions when filing your return instead of claiming the standard deduction.

However, the Tax Cuts and Jobs Act of 2017 roughly doubled the amount of the standard deduction, making it a far more attractive option than itemizing for the majority of taxpayers.

For some taxpayers, it still makes sense to itemize. But those folks might be in for a surprise when they calculate their mortgage interest deduction.

The 2017 tax law limited the deduction to interest on up to $750,000 in mortgage debt — but did not index that limit for inflation — according to accounting firm Grant Thornton.

The explosion in home values for the past few years likely means that a larger percentage of people are taking out mortgages that exceed that limit, which in turn means some of their mortgage interest no longer is deductible.

3. Net investment income tax (NIIT) exemption

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The Health Care and Education Reconciliation Act of 2010 created a new tax known as the net investment income tax, or NIIT, which took effect in 2013. This is a 3.8% levy that applies to income such as:

  • Interest
  • Dividends
  • Capital gains
  • Rental and royalty income
  • Non-qualified annuities

Many taxpayers are fully exempt from the NIIT, meaning none of their income is subject to it. Specifically, the tax applies to people with a modified adjusted gross income of more than the following amounts:

  • Married filing jointly: $250,000
  • Married filing separately: $125,000
  • Single: $200,000
  • Head of household: $200,000
  • Qualifying widow(er) with dependent child: $250,000

But those income thresholds are not indexed for inflation. So growing numbers of Americans eventually will owe the NIIT as inflation causes incomes to rise in future years. In other words, a tax that looks like it applies to the “wealthy” now could hit the “middle class” later.

4. Additional Medicare tax exemption

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Even if they didn’t realize it, 2013 was a bad year for taxpayers. Not only did the net investment income tax take effect, but an additional Medicare tax, created by the Affordable Care Act of 2010, went into effect.

Taxpayers owe this tax if their “wages, compensation, or self-employment income (together with that of his or her spouse if filing a joint return) exceed the threshold amount for the individual’s filing status,” the IRS says.

The income thresholds are:

  • Married filing jointly: $250,000
  • Married filing separate: $125,000
  • Single: $200,000
  • Head of household: $200,000
  • Qualifying widow(er) with dependent child: $200,000

While those amounts might seem relatively high, they are not indexed for inflation. That means that over time, more people will end up owing this tax too.

5. Capital loss deduction

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When your stocks tank, one silver lining is that you can sell your hopeless losers and claim a tax deduction for your net losses. This capital loss deduction allows you to offset other income on your return, meaning you owe less to Uncle Sam.

At the risk of sounding ungrateful — after all, any deduction is a good deduction — the capital loss deduction is pretty puny.

Prior to 1976, it was worth up to $1,000. A federal law that was passed that year increased the maximum value to $2,000 in 1977 and $3,000 starting in 1978.

Since then? Crickets.

Because the deduction is not indexed for inflation, its maximum value remains at $3,000. That means it has become much less valuable over the years. In fact, if it had been indexed in 1978, that tax deduction would be worth more than $14,500 today.

6. State and local tax (SALT) deduction

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The Tax Cuts and Jobs Act of 2017 capped the value of the state and local tax (SALT) deduction. The deduction is generally limited to $10,000 per tax return or $5,000 per return for married individuals who file separately — and those caps are not indexed for inflation, according to accounting firm Grant Thornton.

High-income earners who live in high-tax states are most likely to be hurt as inflation erodes the value of this deduction, provided that they itemize their tax deductions. (The SALT deduction is only available to people who itemize their tax deductions rather than claim the standard deduction.)

7. Exclusion for capital gains on a home sale

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Current federal law allows those who sell their homes to exclude from their taxable income a substantial amount of the profits (capital gains) they earn on the sale of a home: up to $250,000 for single filers and $500,000 for married couples who file jointly.

The capital gains exclusion is not an itemized deduction so it’s available to any taxpayer who otherwise qualifies for it. However, the exclusion limits also are not indexed for inflation, meaning this tax break grows less valuable as the bite of inflation increases.

How to offset the sinking value of these deductions

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When inflation strips the value away from key deductions, you can fight back by increasing other deductions that, in some cases, will more than offset any value you have lost.

For example, if you are eligible to open a health savings account, you can save hundreds or even thousands of dollars in taxes simply by contributing to your account.

Increasing contributions to certain retirement savings plans also can lower your tax bill. You may not even be aware of all the breaks to which retirement savers are entitled, as we explain in “Few Baby Boomers Know This Retirement Tax Credit Exists.”

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