Date: October 18, 2022

How Inflation Affects Your Taxes in Retirement

Inflation is an inevitable part of life. It means that prices will increase over time, and (believe it or not), in some cases, that is good news. For example, inflation can help the economy grow more quickly and provides more opportunities for workers to raise their salaries over time. Sometimes it can help countries and individuals with high amounts of debt pay their creditors off more easily, as well. 

However, when it comes to retirement savings and taxes, even for high-net-worth individuals, inflation can be bad news—especially if you do not plan ahead for it.

This article explores the following: 

  • How inflation affects your savings and investments
  • The causes of inflation and its effects
  • Why the IRS raises taxes during inflation
  • When inflation can hit retirees hardest
  • How investment management can reduce retirement taxes

What Is Inflation?

Inflation is the rate of increase in the price of goods and services. It is measured by the Consumer Price Index (CPI), which shows how much it costs to buy, for instance, a loaf of bread and a jug of milk. Some economists say that an excess of currency in circulation can be to blame since the more dollars are floating around, the more common an individual dollar becomes (diminishing its rarity-based value).

The finer details of inflation are too complicated to get into all of its causes here. However, you can expect it to affect your taxes over time. Congress often increases tax brackets to account for inflation. This means that a certain income level will be taxed at a higher rate than in the past.

The IRS also adjusts other numbers, including the standard deduction and personal exemption. If they did not adjust them, changes in your spending power could increase your tax liability through “bracket creep” (or when you enter a higher tax bracket because of inflation-driven wage growth):

  • The standard deduction is a dollar amount subtracted from your income before you calculate your tax liability. This can be a reasonable choice for some taxpayers, but it may not be the best option for those with enough qualifying expenses (to itemize their deductions for a greater deduction than the standard deduction).
  • The personal exemption is another way for taxpayers to lower their taxable income. This one also adjusts every year with inflation, so it goes up as prices increase. The IRS goes into detail about it here.

The Professional Advantage

In addition to utilizing tax bracket adjustments, one of the best options for retirees is getting investment advice from a wealth manager that specializes in retirement planning. They can help you reduce the tax impact of inflation on your retirement income and help make sure that you are prepared—by taking advantage of all available financial opportunities.

A fiduciary advisor will also work with you to help you set attainable financial goals, giving advice on how best to achieve them. This can include managing your investments so that they grow over time. As inflation increases at a modest pace, your earnings from investments should be able to keep up with rising prices without sacrificing returns too much.

However, this is not always the case. Part of this is due to the fact that inflation lowers the value of money over time. When that happens, buying things like food and clothing that are essential for life becomes more expensive. Gradually, this can mean less money to pay for other important purchases like housing or education.

Unfortunately, it also means that inflation can affect your income during retirement. For example, your savings in the bank could lose value because of rising prices: As the price of goods goes up, there is less money available per dollar in your savings than before (assuming no interest rate changes). As a result, your savings may not increase as quickly as they did when you were younger and earning regular paychecks.

When this is the case, your taxes owed can increase substantially due to the increased deductions allowed under standard deduction provisions.


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Reduce the Tax Impact of Inflation

There is good news, as well: It is possible to somewhat reduce the tax impact of inflation by investing in tax-efficient investments like dividend-paying stocks and funds (that are held for at least 12 months). These allow you to defer the taxes on long-term capital gains, which are taxed at a lower rate than regular income. As a result, you can save thousands in taxes over time, especially if your overall portfolio contains high amounts of dividend-paying stocks.

However, it’s worth noting that dividends are taxed in the year in which they’re earned (whether they are reinvested or not). Additionally, there is no quick-and-easy fix for inflation or its effect on our taxes. Getting proactive about keeping your portfolio balanced and diversified can often help to some degree. We can also watch for any adjustments the IRS makes that might create potential tax breaks. 

Taxes on Social Security

Unfortunately, if you file a tax return as an individual with a combined income of over $25,000, Social Security benefits are considered taxable by the IRS (since they’re additional income). A possible upside of this is that you’re only taxed on up to 85% of them. If you are married and file jointly, having a combined income of over $32,000 is the determining factor.

Another possible upside is the fact that with precise financial planning, your Social Security tax liability may be reducible. The most obvious step is minimizing your retirement income sources. For example, strategically timing IRA withdrawals before you sign up for Social Security benefits can reduce the amount of interest your savings are earning by then. 

Taxes on Withdrawals

If you make a withdrawal (also known as a “distribution”) from your IRA, you will be assessed taxes on that money. The same is true if you withdraw from a 401(k) or another qualified plan. Both IRA and 401(k) withdrawals are taxed at the same rate as your marginal income tax bracket: The higher that bracket is, the more money you will owe on your withdrawal.

Charity can also come back to you—in the form of tax breaks once you’re older than 70½: Up to $100,000 of your annual RMD can go to the qualifying cause of your choice. While you can’t claim a deduction for your gift, you don’t have to include that distribution in your AGI.

A Registered Investment Advisor in Connecticut Can Help

RIA blocks on deskThe takeaway here is that inflation can have an impact on your retirement savings and your resulting taxes if they are not managed properly. To avoid these problems, consider using an advisor who specializes in helping people prepare for—and minimize their tax liability during—retirement. A fiduciary registered investment advisor can also help you understand the impact of inflation on your investment plans. 

At Heritage Capital, LLC, we have been doing all of these things on a daily basis for years. Our asset management specialty is high-net-worth retirement planning in Connecticut. We are confident enough to offer you obligation-free engagement, as well. Contact us today to learn more about how you can retire with confidence in Woodbridge.

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Paul Schatz, President, Heritage Capital