Here’s how rising inflation may affect your 2021 tax bill

Rising inflation image – Ed Jones | AFP | Getty Images

Inflation is still rising, and while many notice the surge in day-to-day expenses, climbing prices may also affect your tax bill, experts say.

The consumer price index, the prime inflation gauge, rose by 7% in December compared to the prior year, the fastest increase since 1982, according to the U.S. Department of Labor. Consumer borrowing rates are due to rise too, with Federal Reserve Chairman Jerome Powell saying he expects a series of rate hikes this year to combat the growing cost of living.

While the IRS boosted federal income tax brackets for 2022, standard deductions, 401(k) plan limits and more, other provisions remain unchanged, leading to higher levies over time.

“It’s a hodgepodge of things that get left out,” said certified financial planner Larry Harris, director of tax services at Parsec Financial in Asheville, N.C. “And it’s not just hitting wealthy taxpayers.”

For example, couples who file together and are selling their primary home may exclude up to $500,000 of profit from capital gains taxes ($250,000 for single filers), provided they meet the ownership and use tests. But these amounts haven’t changed since 1997, despite median home sales prices more than doubling over the past 20 years, and property values have outpaced wages over the past decade.

These fixed exemptions are by design, according to Leonard Burman, institute fellow at the Urban Institute and co-founder of the Tax Policy Center. “I think the intent was for that exemption level to decline in value over time,” he said. “Basically, it’s a way of phasing in a tax increase or at least limiting the revenue costs.”

Basically, it’s a way of phasing in a tax increase or at least limiting the revenue costs.

Leonard Burman


The thresholds for taxes on Social Security benefits have also stayed the same for decades. Currently, up to 85% may be taxable if adjusted gross income, levy-free interest and one-half of Social Security benefits exceed $34,000 for single filers and $44,000 for married couples filing jointly.

“I think the intent was to have more Social Security benefits taxable over time,” Burman said. “And it was a way to slow the hemorrhaging of the Social Security trust fund.”

Surcharge for higher earners

Another fixed provision is the thresholds for a 3.8% surcharge on investment income put in place by former President Barack Obama.

The levy kicks in when modified adjusted gross income passes $200,000 for single filers and $250,000 for couples, and those floors haven’t adjusted, creating a tax hike for higher earners every year, Harris said.

And the controversial $10,000 limit on the federal deduction for state and local taxes, known as SALT, hasn’t budged since 2018. House Democrats passed a bump up to $80,000 through 2030 as part of the Build Back Better legislation that has stalled in Congress.

“It really does hammer lots of people depending on what state you live in,” Harris said.

State Taxes

Some filers may also have higher state tax burdens in places without inflation adjustments for tax brackets, the standard deduction or personal exemptions.

While 41 states and the District of Columbia tax wages, 23 have at least one major unindexed tax provision, according to a Tax Foundation analysis, and 13 don’t index any of these components.

That amounts to “unlegislated tax increase every year,” the analysis argues, reducing wage growth and return on investment, particularly during inflationary periods.

While unchanged provisions may sting certain taxpayers during inflationary periods, it’s difficult to gauge the damage without running a tax projection, Harris at Parsec Financial said, adding most people’s returns have “too many other moving parts.”


Kate Dore, CFP®