Inflation causes higher bills everywhere, from your favorite grocery store to the car dealership. It can also deduct the value of some major tax deductions and exemptions.
A number of seemingly immediate federal income tax breaks are not indexed for inflation, meaning they are not automatically adjusted every year or so – if ever – to offset increases in the cost of living.
So these snippets and exclusions become less valuable — or become accessible to fewer people — over time.
Federal tax breaks that have been destined to suffer this fate include the following.
1. Exemption from Social Security income tax
Many new retirees are surprised that their Social Security benefits are taxable. But Uncle Sam isn’t exactly cold-hearted: He doesn’t tax 100% of retirement benefits.
Anywhere from 0% to 85% of retired Social Security benefits are subject to income tax. The exact rate depends on the retirement tax filing status and what the federal government calls their “combined income.”
For example, a retired couple who files joint tax returns and has a combined income of between $32,000 and $44,000 will owe taxes of up to 50% of their Social Security benefits. Couples who exceed $44,000 will owe up to 85% of their support in taxes.
But this income threshold is not adjusted for inflation. This is a big problem for millions of retirees. When Social Security benefits were first taxed in 1984, it was projected that 10% of recipients would owe taxes. However, because the threshold is never indexed for inflation, we have gotten to the point where more than half of those on Social Security owe taxes on their benefits.
2. Mortgage interest deductions
The mortgage interest deduction isn’t nearly as valuable as it was in the past. To qualify for this tax break, you must itemize your deductions when filing your return instead of claiming the standard deduction.
However, the Withholding Taxes and Employment Act of 2017 roughly doubles the standard deduction amount, making it a much more attractive option than itemizing for the majority of taxpayers.
For some taxpayers, it still makes sense to break down. But those people may be surprised when they calculate their mortgage interest deduction.
A 2017 tax law limits deductible interest to $750,000 in mortgage debt – but doesn’t index that limit for inflation – according to accounting firm Grant Thornton.
The explosion in home values over the past few years likely means a larger percentage of people are taking out mortgages that exceed the limit, which in turn means some of their mortgage interest is no longer deductible.
3. Exemption from net investment income tax
The Health Care and Education Reconciliation Act of 2010 created a new tax known as the net investment income tax, or NIIT, which went into effect in 2013. This is a 3.8% levy that applies to income such as:
- Interest
- Dividend
- Capital gains
- Rent and royalty income
- Unqualified annuity
Many taxpayers are fully exempt from NIIT, meaning none of their income is subject to NIIT. In particular, the tax applies to persons with a modified adjusted gross income of more than the following amounts:
- Married file jointly: $250,000
- Married file separately: $125,000
- Singles: $200,000
- Head of household: $200,000
- Eligible widows with dependent children: $250,000
But those income thresholds are not indexed for inflation. So more and more Americans will end up in debt to NIIT as inflation causes incomes to increase in the coming years. In other words, a tax that seems to go to the “rich” now could hit the “middle class” later.
4. Additional Medicare tax exemption
Although not realized, 2013 was a bad year for taxpayers. Not only is the net investment income tax in effect, but an additional Medicare tax, created by the Affordable Care Act of 2010, is taking effect.
Taxpayers owe this tax if their “wages, compensation, or self-employed income (together with that of their spouse if filing a joint return) exceed the threshold amount for individual filing status,” the IRS says.
The income threshold is:
- Married file jointly: $250,000
- Married filing separately: $125,000
- Singles: $200,000
- Head of household: $200,000
- Eligible widow(er) with dependent children: $200,000
While the number may appear relatively high, it is not indexed for inflation. That means that over time, more people end up having to pay this tax too.
5. Reduction of capital losses
As your stock runs low – and millions of people could relate to that scenario in 2022 – one silver lining is that you can sell hopeless losers and claim a tax deduction on your net loss. This reduction in capital losses allows you to offset other income on your returns, meaning you owe less to Uncle Sam.
At the risk of sounding ungrateful — after all, any reduction is a good reduction — the capital loss reduction is quite small.
Before 1976, it was valued at $1,000. Federal law passed that year increased the maximum value to $2,000 in 1977 and $3,000 starting in 1978.
Since a long time ago? Cricket.
Because the deduction is not indexed for inflation, the maximum value remains at $3,000. That means it’s become a lot less valuable over the years. In fact, if it had been indexed in 1978, that tax deduction would be worth more than $14,000 today.
6. State and local tax deductions (SALT).
The Employment and Tax Withholding Act of 2017 limits the amount of state and local tax deductions (SALTs): Deductions are generally limited to $10,000 per tax return (or $5,000 per return for married individuals filing separately) — and the limit is not indexed for inflation, according to accounting firm Grant Thornton.
High-income people who live in high-tax states are likely to be at a disadvantage as inflation erodes the value of these deductions, provided they itemize their tax deductions. (SALT deductions are only available to people who itemize their tax deductions rather than claiming a standard deduction.)
7. Exceptions for capital gains from the sale of a home
Current federal law allows those who sell their homes to exclude from their taxable income a large portion of the gain (capital gain) they earn from selling the home: up to $250,000 for single filers and $500,000 for married couples filing jointly.
The capital gains exemption is not an itemized deduction so it is available to any taxpayer who qualifies for it. However, the exclusion threshold is also not indexed for inflation, meaning this tax break becomes less valuable as the inflation bite increases.
How to offset the decrease in the value of the deduction
When inflation takes away value from a key cut, you can fight back by increasing another reduction which, in some cases, will more than offset the lost value.
For example, if you qualify to open a health savings account, you can save hundreds or even thousands of dollars in taxes just by contributing to your account.
Increasing contributions to certain retirement savings plans can also lower your tax bill. You may not even know all of the breaks retirement savers are entitled to, as we explain in “Some Baby Boomers Know These Retirement Tax Credits Exist.”
