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The indexing of many features of the tax code will bring some relief to taxpayers next year, according to CCH Tax and Accounting, a leading provider of tax law information, software and services, which on September 21, 2005, released estimated income ranges for each 2006 tax bracket.
Unlike many changes to the tax laws which are effective for only limited periods of time, indexing has become a settled part of the tax code, according to George Jones, J.D., senior analyst for CCH.
"While some tax cuts in recent years are only temporary, and are scheduled to be followed by increases down the line, indexing works year after year, and it's likely to be a part of the tax laws for the forseeable future irrespective of whether Congress plans to tinker more with the tax rates themselves," Jones noted.
Of course, some temporary changes also have been indexed for inflation during the temporary period they will exist.
"That just adds to the need to check the size of each tax benefit, every year," added Jones.
Interplay of Indexing, Tax Changes
Indexing of brackets lowers tax bills by including more of people's incomes in lower brackets--in the 15-percent rather than the 25-percent bracket, for example.
"This also means that across-the-board inflation adjustments to the brackets provide more relief for those in the upper brackets, since they share in the reduction within each bracket, not just their own marginal tax bracket," Jones said.
Two examples show the modest tax savings generated by indexing:
Because of inflation adjustments, a married couple filing jointly with total taxable income of $100,000 will pay $215 less in income taxes in 2006 than they will on the same income for 2005.
A single filer with taxable income of $50,000 will save $107.50 next year due to the adjustments.
Inflation Adjustments
Since the late 1980s, the U.S. tax code has required that federal income tax brackets be adjusted for inflation annually, and inflation adjustments have been inserted into the Internal Revenue Code in recent years with increasing frequency. For example, the Code now requires over 50 other inflation-driven computations to determine deduction, exemption and exclusion amounts in addition to the 40 separate computations needed to inflation-adjust the tax bracket tables each year.
The adjustments are based on Consumer Price Index figures for September through August immediately prior to the adjusted year. CCH's projections are based on the relevant inflation data released September 15, 2005, by the U.S. Department of Labor.
The IRS usually releases official numbers by December each year. CCH tax bracket projections are provided for illustrative purposes only, and should not be used for income tax returns or other federal income tax related purposes until confirmed by the IRS later this year.
Some Items Not Indexed
Jones observed that some items in the Code are not indexed for inflation and stay the same, while others rise from 2005 to 2006 by dollar amounts already written into the tax law.
"The maximum amount of modified adjusted gross income allowed for rolling over a regular IRA into a Roth IRA has been stuck at the $100,000 level since 1998 and will remain there for 2006, with no inflation adjustment. The limit on 401(k) plan elective deferrals, on the other hand, has a $1,000 increase built in by the Internal Revenue Code; that brings the maximum amount of pre-tax salary allowed to be socked away in a 401(k) plan to $15,000 in 2006," Jones observed. "Beginning in 2007, the deferral amount will be indexed, which will provide far less than the $1,000 annual increases to which participants have grown accustomed."
Standard Deduction, Personal Exemption Also Rise
The standard deduction and personal exemption are also subject to indexing, and these are projected to increase for 2006. These increases can produce lower taxes by lowering the taxpayer's taxable income.
Single taxpayers and married taxpayers filing separately could see a $150 increase over 2005 in their standard deduction, to $5,150, while the standard deduction for joint filers will increase by $300 to $10,300. Heads of households will see an increase in their standard deduction of $250, to $7,550.
The additional standard deduction for those age 65 or older or who are blind, however, will remain the same as in 2005: $1,000 for married individuals and surviving spouses, and $1,250 for single filers. The personal exemption amount will go up in 2006 by $100 to $3,300.
These inflation adjustments can add up over time. For example, since the 1987 tax year, the standard deduction for joint filers has increased more than two- and-a-half times, from $3,780 to the anticipated $10,300 amount for 2006.
Taxpayers can, however, lose a good portion of the value of personal exemptions and itemized deductions when their incomes rise above certain levels. Those "phaseout" levels are also adjusted for inflation. For 2006, married couples filing jointly will begin to lose some of the value of any itemized deductions when their adjusted gross income exceeds $150,500. Likewise, they will begin to lose some of the value of their personal exemptions when their adjusted gross income exceeds $225,750. Starting next year, however, some relief from this "stealth tax" will begin to kick in.
In 2006 and 2007, the reduction in personal exemptions and itemized deductions is scheduled to be only two-thirds of what it is now. That's because both "phaseouts," first started under the Revenue Reconciliation Act of 1990, are themselves now scheduled to be phased out by one-third in 2006 and 2007, two-thirds in 2008 and 2009 and completely repealed starting in 2010.
"Kiddie" Deduction, Gift Tax Exemption
In general, inflation adjustments are rounded to the next-lower multiple of $50, so if the adjustment produces an increase of less than $50, no increase is made. The "kiddie" standard deduction, used on the returns of children who are claimed as dependents on their parents' returns increased in 2001, from $700 to $750, and jumped next to $800 for 2004. For 2006, it increased to $850.
The tax code only allows the gift tax exemption to rise when the inflation adjustment would produce an increase of $1,000 or more. The last increase occurred at the beginning of 2002, when the exemption increased to its current $11,000. This year's inflation figures just push the amount above the next threshold, so the exemption will rise to $12,000 for 2006.
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Added to the news on September 30, 2005.
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