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The lowdown on tax brackets – New adjustments for the new year

In late October, the Internal Revenue Service announced its ‘21 (tax year) inflation adjustments. It wasn’t exactly an “October surprise,” as many of the changes outlined are about as predictable as, well, death and taxes. However, while the adjustments pertained to more than 60 tax provisions, the IRS spotlighted a handful that they characterized as of greatest interest to the taxpayer. Notably, these adjustments related to raising the ceiling on tax brackets. Ceilings were also lifted in relation to standard deductions, which reduces the amount of taxable income (or earnings subject to federal taxes).

Some items remained unchanged; for instance, the personal exemption is consistent (at “0”) for 2021, just as it was in 2020 (the exemption was eliminated as part of the Tax Cuts and Jobs Act signed into law in 2017). Tax rates themselves remain unchanged, from 10% to 37%, with the 24% rate right in the middle.

The updated, inflation-adjusted rates and corresponding taxable income is as follows, in ascending order and based off of how taxpayers file:

These rates are designed to be “equalizers,” and to minimize what the independent policy nonprofit, Tax Foundation, characterized as “bracket creep.” Adjustments for inflation are made to prevent taxpayers from being pushed into higher income brackets and being subject to reduced credits and deductions – due to inflation, not due to increases in real income. Additionally, the brackets were designed to acknowledge the lowest earners. So, they’re not having to pay the same rate as the highest earners.

In 1913, when the federal income tax was born, the language of the legislation fit into a whopping four pages. The top tax bracket stood at 7% across all income over $500K (which is like $11 million in today’s monies). The lowest tax bracket was reportedly 1%, a floor that we would never see again. World War II brought with it a through-the-roof rate of 94% for the highest earners, who made the equivalent of $2.5 million today ($200K in 1944).

As a progressive tax system, portions of relevant income are taxed differently. For instance, if the single-filing reader falls squarely into the 22% tax rate (earning $80,000 annually), he or she does not actually pay 22% on all of that income. Looking at the above bullet points, the reader is taxed at 10% for the first $9,951 of that income, then 12% for the next $9,951 to $40,525, and so on until the balance of the remaining income is taxed at the highest rate (22%). If one adds up those amounts (taxed at 10%, 12%, and 22%) the tax liability comes out to around 17%.

A note on the cause for change: inflation rates

Formerly, before 2018, the IRS used the Consumer Price Index as the measure of inflation and to gauge annual increases to income brackets (and corresponding deductions and credits). Since the TCJA was enacted, the IRS has used the Chained Consumer Price Index as the basis for adjustments to income/brackets, deductions and credits values and amounts.

CPI accounts for how the prices of goods, such as food, change over time. Consider how what we paid for a gallon of milk or a loaf of bread in 2011 isn’t what we paid in 2021, let alone in 1991 or 1971. The CPI plays a vital role in cost-of-living adjustments for the likes of government programs (such as Social Security and food stamps). The AARP defines the Chained CPI (C-CPI) as a “twist” on the original formula. Costs of living are measured differently. The C-CPI accounts, partly, for variations in consumer behavior; for instance, consumers will settle for more affordable substitutes if the prices go up. An example in action might be buying off-brand pasta versus the big-name brands, or opting for poultry rather than salmon or expensive cuts of beef. As you might expect, the C-CPI increases more slowly over time than the original CPI (CPI for All Urban Consumers or CPI-U). Between 2000 to 2019, CPI-U rose by almost 48%, while C-CPI approached a 41% increase – a difference of 7%. Since these formulas are so tied to benefits and compound with time, these differences can really add up.

To give one a sense as to how CPI formulas play into annual increases, consider that the annual inflation rate for the U.S. stood at 1.4% for the year ended December 2020. The year prior rate was 1.2%, according to data released by the Bureau of Labor Statistics in early January.

More on the standard deduction

As mentioned, it’s not just income limits that are subject to annual hikes. To account for inflation, the IRS reports that the standard deduction amounts were adjusted by the following, dependent again on how the taxpayer files:

  • $25,100 – an increase of $300 – for married joint filers

  • $12,550 – an increase of $150 – for married single filers and single, individual filers

  • $18,800 – an increase of $150 – for heads of households

Eligible single filers might take the deduction, instead of itemized deductions, and in turn they wouldn’t be taxed on the first $12,550 of their income. Remember: The taxable income is separate from your total, gross income. Start with the total and apply those tax deductions and adjustments that you qualify for, using either the standard or itemized deduction route (depending on what behooves you more). Additionally, we’ve referenced the “head of household” filing throughout, which might be applicable to those readers who are unmarried and have dependents (single mothers and fathers, for instance). As you’ve seen, income thresholds can also vary widely depending on if you as a married individual file separately or jointly with your spouse.

For a full list of changes enacted for the 2021 tax year, we encourage you to visit the IRS rundown of adjustments here. And, of course, don’t hesitate to reach out to your trusted tax partners at O’Donnell, Ficenec, Wills & Ferdig.

OFWF has been serving individuals and organizations in the metro Omaha area for more than 70 years.

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