5 ways inflation could impact your paycheck next year
Many Americans are hoping for wage gains to offset the hottest inflation in 40 years, but there are a number of factors that could impact your take-home pay in 2023. And because inflation is rising so sharply, the IRS and other agencies are changing many rules to account for the increase in prices.
For instance, the tax agency on Tuesday said it's boosting its 2023 tax brackets by 7% because of inflation, a move designed to avoid "bracket creep" — when people get pushed into higher tax rates because of cost-of-living salary adjustments although their standard of living hasn't changed. The IRS is also increasing the standard deduction by the same percentage, which will benefit most taxpayers who use this tax break.
"Inflation adjustments to tax brackets mean that it will be harder for taxpayers to hit those higher brackets, and therefore will have more income taxed at lower rates next year," noted Tim Steffen, director of tax planning with Baird, in an email.
The interplay of these changes is complex, but the upshot is that low- and middle-income taxpayers may be able to trim their taxes as a result. The outlook is more complicated for higher-income workers because of an inflation-adjusted boost in the cap for Social Security taxes.
Below are five inflation-related changes that could impact your paycheck next year.
An annual raise — good but maybe not enough
For 2023, employers plan to offer their workers an annual raise of 4%, according to a recent survey from Salary.com. That's roughly in line with the median pay bump employees got in 2022.
The problem is that inflation this year has been running at about twice that rate, with prices rising 8.2% in September from a year ago. Economists at the Federal Reserve expect inflation to subside later this year and into 2023, although the central bank has been criticized for its call last year that the sharp rise in prices was "transitory."
If the Fed is correct in predicting that inflation will decline to 2.8% next year, that will restore some purchasing power for consumers in 2023. So far, though, inflation has remained stubbornly sticky.
More generous tax brackets
As mentioned above, the IRS is boosting its taxable income thresholds for its seven tax brackets, which range from 10% to a top rate of 37%. The higher limits could result in tax savings for some people, with Baird's Steffen estimating that a married couple earning $200,000 in both 2022 and 2023 could save $900 in taxes next year.
You can find the new tax brackets here.
Higher retirement contribution limits
The IRS on Friday said it is boosting the 2023 contribution limits for 401(k) plans by a record $2,000 due to inflation, which will allow workers to save more money in 2023.
Individuals will be able to save up to $22,500 in their 401(k)s next year, an increase of almost 10% from the current year's limit of $20,500, the agency said. The new cap also applies to other types of defined contribution plans, including 403(b), most 457 plans and the federal government's Thrift Savings Plan.
It's the biggest inflation adjustment since 401(k) plans began indexing to inflation in 2007. Typically, the IRS has increased the contribution limit by either $500 a year or kept it at the same level since the plans began instituting cost-of-living increases 15 years ago.
The IRS said the contribution limit for IRAs will increase to $6,500 next year, a boost of 8.3% from the 2022 limit of $6,000.
However, the catch-up contribution for people over the age of 50 will remain at $1,000, because that rule isn't subject to an annual adjustment for inflation, the agency said.
Raising the cap for Social Security tax
The Social Security Administration taxes wages to fund the program, but it caps the amount of individual earnings that can be taxed within a calendar year. That cap changes every year to align with the national average wage index.
Because of inflation, the taxable maximum will rise to $160,200, an increase of almost 9% from the current cap of $147,000. That means higher earners will pay a Social Security tax of 6.2% on that additional $13,200 of income next year.
"The increase in the Social Security wage base will work against taxpayers, though, as more of their wages will be subject to the 6.2% tax," Steffen said. "For someone whose income exceeds that threshold next year, it will feel like a tax increase of over $800."
Setting aside more pre-tax dollars for health care
Workers with access to Flexible Spending Accounts and Health Savings Accounts can set aside more pre-tax dollars next year due to inflation adjustments.
In 2023, employees can put away as much as $3,050 in a FSA, an increase of about 7% from the current tax year's cap of $2,850. Meanwhile, single workers who want to fund an HSA can save up to $3,850 next year, a 5.5% increase from 2022, while families can save up to $7,750, up 6.2%.
That could give you more tax savings, although the money you set aside must be used for health care expenses.