In recent years, inflation existed but was not significant. Significant inflation was associated with wide lapels and eight-track tapes and thought to be left behind in the late 1970s and early 1980s.
But, sure enough, significant inflation is back. Inflation is 6.2 percent for the 12 months ending October 2021.
Inflation has a tax angle. How does one use tax planning to minimize the impact of inflation? In this post, I review the issues associated with inflation and tactics to consider if one is concerned about inflation.
Inflation: The Tax Problem
Inflation increases the nominal (i.e., stated) value of assets without a corresponding increase in the real value of the asset. Here is an example:
Larry buys $100,000 worth of XYZ Mutual Fund on January 1, 2022. During the year 2022, there is 10 percent inflation. On January 1, 2023, the XYZ Mutual Fund is worth $110,000. Inflation-adjusted, the position has the same real value as it did when Larry purchased it. However, were Larry to sell the entire position, he would trigger a $10,000 capital gain ($110,000 sales price less $100,000 tax basis), which would be taxable to him.
Hopefully you see the problem: Larry has not experienced a real increase in wealth. Larry’s taxable “gain” is not a gain. Rather, it is simply inflation! Larry will pay tax on inflation if he sells the asset. Ouch!
While inflation increases the nominal value of assets, there is no inflation adjustment to tax basis! Thus, inflation creates artificial gains subject to income tax.
There are other tax problems with inflation. Inflation artificially increases amounts received as wages, self-employment income, interest, dividends, and retirement plan distributions. Those artificial increases are not real increases in income (as they do not represent increases in value) but they are subject to income tax as though they were real increases in income.
The tax law does provide some remedy to address the problem of taxing inflation. The IRS provides inflation adjustments to increase the size of progressive tax brackets. In addition, the standard deduction is adjusted annually for inflation. Recently the IRS released the inflation adjustments for 2022.
IRS inflation adjustments are helpful, but they do not excuse inflation from taxation. Rather, they only soften the blow. Thus, they are not a full cure for the tax problems caused by inflation.
Inflation and Traditional Retirement Accounts
Inflation is detrimental to traditional retirement accounts such as pre-tax 401(k)s and IRAs. Holding assets inside a traditional retirement account subjects the taxpayer to income tax on the growth in the assets caused by inflation.
Inflation artificially increases amounts in these accounts that will ultimately be subject to taxation. Inflation can also limit the opportunity to do Roth conversions in early retirement. Greater balances to convert from traditional to Roth accounts and increased dividend, capital gain, and interest income triggered by inflation makes early retiree Roth conversion planning more challenging.
Inflation and Real Estate
There are several tax benefits of rental real estate. One of the main benefits is depreciation. For residential real estate, the depreciable basis is deducted in a straight-line over 27.5 years. For example, if the depreciable basis of a rental condo is $275,000, the annual depreciation tax deduction (for 27.5 years) is $10,000 (computed as $275,000 divided by 27.5). That number rarely changes, as most of the depreciable basis is determined at the time the property is purchased or constructed.
Over time, inflation erodes the value of depreciation deductions. Inflation generally increases rental income, but the depreciation deduction stays flat nominally and decreases in real value. Increasing inflation reduces the tax benefits provided by rental real estate.
Planning Techniques
There are planning techniques that can protect taxpayers against the tax threat posed by inflation.
Roth Contributions and Conversions
Inflation is yet another tax villain the Roth can slay. Tax free growth inside a Roth account avoids the tax on inflation.
Once inside a Roth, concerns about inflation increasing taxes generally vanish. Properly planned, Roths provide tax free growth and tax free withdrawals. Thus, Roths effectively eliminate the concern about paying tax on inflation.
For those thinking of Roth conversions, inflation concerns point to accelerating Roth conversions. The sooner amounts inside traditional retirement accounts are converted to Roth accounts, the less exposure the amounts have to inflation taxes.
Roth contributions and conversions provide tax insurance against the threat of inflation. For those very concerned about inflation, this consideration moves the needle toward the Roth in the ongoing Roth versus traditional debate.
Health Savings Accounts
A Health Savings Account, like its Roth IRA cousin, offers tax free growth. HSAs also protect against taxes on inflation. Inflation is another argument to take advantage of an HSA.
Basis Step Up Planning
There is another tax planning opportunity that can wipe away the taxes owed on years of inflation: the basis step up at death. At death, heirs receive a basis in inherited taxable assets which is usually the fair market value of the assets on the date of death. For taxable assets, death provides an opportunity to escape the tax on inflation.
It is important to note that traditional retirement accounts do not receive a basis step up. Inflation inside a traditional retirement account will eventually be subject to tax (either to the original owner or to a beneficiary after the original owner’s death).
During one’s lifetime, there is the tax gain harvesting opportunity to step up basis and reduce inflation taxes. The tactic is to sell and repurchase an investment with a built-in gain at a time when the investor does not pay federal income tax on the capital gain. If one can keep their marginal federal income tax rate in the 12% or lower marginal tax bracket, they can pay a 0% federal income tax rate on the gain and “reset” the basis to the repurchase price of the sold and then repurchased asset.
There is a second flavor of tax gain harvesting: triggering a capital gain (at an advantageous time from a tax perspective) by selling an asset and reinvesting the proceeds in a more desirable asset (essentially, investment reallocation).
One inflation consideration with respect to tax gain harvesting: as inflation increases interest and dividends, there will be less room inside the 12 percent taxable income bracket to create capital gains that are federal income tax free.
Conclusion
Inflation is yet another tax planning consideration. As we are now in a period of significant inflation, taxpayers and advisors will need to weigh inflation’s potential impact on tax strategies.
None of the above is advice for any particular taxpayer. Hopefully it provides some educational background to help assess the tax impact of inflation and consider tactical responses to inflation.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
