What taxes do not adjust for inflation?
Posted on July 5, 2024
Our Social Security benefits and the key items that affect taxes we pay adjust for inflation. For example, the start of tax brackets for ordinary income adjust for inflation each year: we pay the same real amount in taxes on the same real amount of ordinary income. This post discusses three key items that do not adjust for inflation: for the same real income, you could pay more tax.
• One affects retirees who do not have a lot of income in addition to Social Security. These folks do not reach the 85% maximum that is taxed. The base income that drives the calculation of the percentage that is taxed does not adjust for inflation. A greater percentage of Social Security is taxed when real income has not increased. Increased taxable income, eventually can trigger 15% tax on dividends and capital gains, not 0%.
• Two others affect those with higher income. 1) Those with enough total income are subject to 15% capital gains tax. They will pay tax on an inflation portion of their gain, because the cost basis of a security sold does not adjust for inflation. 2) Taxpayers with high income can cross the threshold of income that results in the Net Investment Income Tax (NIIT): the income level that determines whether or not you pay this tax does not adjust for inflation.
Details:
Social Security benefits adjust for inflation; that means we get the same spending power over time. Marginal tax brackets adjust for inflation: we pay the same real amount of tax on the same real amount of ordinary income. Since 2020 income tripwires that trigger higher Medicare premiums (IRMAA) adjust for inflation: you don’t inch closer to a tripwire because of inflation.
Three do not adjust for inflation.
== Taxable percentage of Social Security ==
The percentage of Social Security that is taxed ranges from 0% to a maximum of 85%. The math that gets to the percentage is a bit complex as shown here. Income greater than a base amount results in some portion of Social Security that is taxable. The base amount does not adjust for inflation. Folks paying less than the 85% maximum pay tax on a greater percentage and therefore on a greater real amount of income because of inflation.
This affects those taxpayers without a lot of income in addition to Social Security. Roughly half of all retires have added income that is not greater than their Social Security benefit. (Folks with added income that is much greater than their Social Security benefit are already paying the maximum 85%; they are unaffected by this calculation.)
In this example, I increase Social Security and all other income for the ~18% inflation over the past three years. The percentage that is taxed increased from 30% to 45%: 50% more of the benefit is taxed solely because of inflation.
Over time, more and more taxpayers reach the maximum of 85% taxable for SS. At that level, most all are subject to 15% capital gains tax rate, not 0%.
== Capital Gains ==
Those with enough total income pay 15% tax on long-term capital gains. The cost basis of an investment – perhaps purchased years ago – does not adjust for inflation. A component of the calculated gain is inflation. You are being taxed on the real gain and on inflation.
The effect can be relatively large for short holding-periods. If the nominal gain was 9% when inflation was 9% for that period, the real gain was 0%. The 9% gain is solely from inflation. You pay 15% tax solely on inflation. Your net proceeds, adjusted for inflation, are less than you invested.
I judge the effect over the long run, and I conclude the effect is small for most of us. I’ve held some of my taxable investments for decades, and the real component of return dwarfs the component that is inflation. A simple example shows that over decades you are paying about 15% more in tax than you would on the real gain – about 17.5% effective capital gains tax rate and not 15%. The differential shrinks as the holding period lengthens – as the magnitude of real gain continues to outpace the inflation component of gain.
== Net Investment Income Tax (NIIT) ==
NIIT is a 3.8% surcharge on a portion of investment income – generally interest, dividends, capital gains. The portion subject to tax is the amount that exceeds $200,000 MAGI for single filers or $250,000 MAGI for married, joint filers. (For most all of us retirees, MAGI for this purpose equals AGI.) These thresholds do not adjust for inflation.
Example: A single filer has total investment income is $40,000. MAGI is $225,000. $25,000 is the investment income in excess of $200,000. The NIIT surcharge is 3.8% of $25,000 or $950.
Roughly, the top 5% of all taxpayers pay NIIT. I’d guess that less than 5% of retirees have income at this level. About 7 million taxpayers now pay NIIT, more than double the number in 2013. You may be far away from this threshold, but, because of inflation, you are inching closer to it year after year.
Conclusion: Three tax items that affect retirees do not adjust for inflation. The same real income can result in greater taxes. One affects those without a great amount of income in addition to Social Security: the percentage of Social Security that is taxed will increase because of inflation. For those with greater income, the effective capital gains tax is greater than the 15% tax rate because the cost basis of an investment does not adjust for inflation. The base income that triggers the Net Investment Income Tax (NIIT) does not adjust for inflation; over time more and more taxpayers will cross that base amount and pay NIIT.