Explain It to Me Like I Went to Art School: 2023 IRS Tax Changes
Updated: Jan 20
You might have heard on the news recently that the IRS announced tax changes for 2023. However, for those who don’t hyperfocus on numbers all day, every day, it’s understandable if reading past that headline made your head swim. So here’s the Thrive Guide to recent events: 2023 Tax Changes Edition.
**Keep in mind that these changes are for the 2023 tax year. The taxes that you file in April are for the 2022 tax year. So this information is for planning your new year’s budget, not filing this coming April. There is, however, a chance that you may see some of the benefits of these changes starting in January.**
Before we get into the details, we wanted to answer one big question we keep getting asked: Are these changes normal? Why are they making headlines this year? The answer is both yes and no. The IRS does make yearly adjustments for inflation every tax year. That part is absolutely normal. There are also sometimes changes when tax legislation is passed.
The reason these changes in particular stand out is because of the magnitude of the changes. 2023 will have a particularly generous increase to account for inflation: 7%. In fact, that 7% makes up the biggest inflation adjustment to automatically increase the standard deduction since 1985, when many current business owners, and nearly 40% of the workforce had yet to be born, or in the case of us elder millennials, we had yet to enter kindergarten. As much as this big increase sounds great, there are some areas of the economy that are currently seeing inflation that exceeds 15-30%... so in some ways it’s not that big of an increase at all.
There’s actually a full 28 page very dry procedural manual which details all of these changes, cross referencing the sections of the tax code that they relate to, for IRS employees and tax professionals. The good news for you is that and here at Thrive, we read it so you don’t have to! There’s a number of interesting changes, and two very important ones, so we’re going to jump right into those. We promise it isn’t scary, it’s even two terms that anyone who has ever filed a tax return is likely already familiar with, even if you don’t have a full understanding of how they work.
The Standard Deduction
Step 1: What actually IS the Standard Deduction?
An estimated 90% of taxpayers in the United States “take the standard deduction”. We couldn’t find any data on how many of those taxpayers understand what it is, however, which is sort of why we started this blog.
The Standard Deduction reduces a taxpayer’s income, so that only households who make over a certain amount of money will owe income tax. Once you have calculated your Gross Income (all the money you made this year), and then your Adjusted Gross Income (taking into account certain special deductions, like IRA contributions or Student Loan Interest), you then adjust your income AGAIN. You can do that the hard way, by itemizing every single tax-deductible expense you had all year (and having the receipts to back all of that up), or you can subtract the standard deduction (and don’t have to worry about keeping track of all those receipts for years). This gives us your taxable income.
Step 2: What changed?
Now, which Standard Deduction you get to take depends on your filing status (aka- whether you put a ring on it at some point). The 2023 Standard Deductions are as follows:
Married Couples Filing Jointly: $27,700 (up from $25,900 in 2022)
Single and Married Filing Separately: $13,850 (up from $12,950 in 2022)
Heads of Households: $20,800 (up from $19,400 in 2022)
Step 3: But What Does it Mean for Me?
A larger standard deduction saves money for most Americans, who don’t have enough tax-deductible expenses (or time and patience) to bother with saving and organizing receipts all year long. Since the standard deduction is subtracted from your income (without you needing to prove that you make a certain amount of tax-deductible purchases), however much your standard deduction is, that much of your income is essentially tax free!
Bonus Question: Why are there two different filing statuses for married couples?
There’s two different options to avoid what is called the “Marriage Penalty”, where combining the incomes of a couple would cause them to pay more in taxes than if they filed as single individuals. This usually only happens to people who make a whole lot of money these days, but if you are worried it might happen to you, we know a good accountant who can assist you in making the best filing decisions.
Marginal Tax Rates
Step 1: What actually ARE Marginal Tax Rates?
Your marginal tax rate is the tax rate you pay on your last dollar of taxable income. (This will make more sense in a minute.) Basically, this typically refers to your highest tax bracket. The marginal tax rates for both 2022 and 2023 are: 37%, 35%, 32%, 24%, 22%, 12%, and 10%.
Which rate you have depends on which tax bracket you fall into. Which brings us to…
Step 1 (revised): What actually ARE Tax Brackets?
First off, it’s not a sports bracket. So you don’t need to like, put your January income against your April income and make them fight or anything like that. Understanding tax brackets actually unlocks the key to understanding what you pay in taxes. To try to make the concept a little easier, we’re going to go through some examples with smaller numbers.
Federal US taxes aren’t paid at one flat rate. A flat rate tax would look something like this:
Instead, let’s picture tax brackets like splitting our money up into different piles. Every single person, regardless of income, pays the same percentage in taxes on the money they make in each bucket. Once the bucket is full, the money goes into the next bucket, and is taxed at the next percentage up. If your money doesn’t spill into the next bucket, you don’t have to worry about paying that percentage.
Rather than paying your top tax percentage on every single dollar that you make, marginal tax rates make sure that everyone in the country pays the same percentage on each dollar that they make in order. Someone who makes $10,000 in a year will only pay $1000, or 10% of that income in taxes. Someone who makes $100,000 in a year will also only pay $1000 in taxes on their first $10,000 in income- as you make more money, the taxes add up.
In other words, if you happened to make exactly $250,000 in taxable income in 2023, and you paid a flat 35% tax on that, you would owe $87,500 total in taxes. At a flat rate, they would be paying $3,500 on that first $10,000 of income. The marginal tax rate not only makes sure everyone is paying the same percentage on each dollar they earn in order, it saves those who make more in the year a lot of money.
Step 2: What changed?
This year, the IRS has adjusted each of the tax brackets to make up for inflation, and to try to avoid what is called “bracket creep”. What’s bracket creep? Basically, when the cost of living goes up, typically wages go up as well to try to balance things out. Remember: if your wages don’t go up more than the cost of living, essentially, you have not gotten a raise. If your wages go up exactly as much as the cost of living, in theory, you are in the exact same financial situation this year as you were last year.
If the IRS doesn’t adjust the tax brackets, this could cause people who are in the “exact same financial situation” to be bumped up a tax bracket, making their tax bill much more expensive than it should be. Adjusting the tax brackets for the cost of living makes sure that those who are only getting cost of living adjustments are not having to pay more than their fair share.
Step 3: But What Does it Mean for Me?
Inflation being what it is this year, you may wind up in a lower tax bracket if your cost of living adjustment didn’t keep up with the cost of living (if you even got one this year). If you happened to be placed into a different tax bracket, it’s likely that starting January 1, 2023, you might see more take home pay in your paycheck each week!
If you don’t see a significant difference, it could mean that you were closer to the top end of your tax bracket, and that nothing changed for you this year. If you got a raise that put you into a higher tax bracket, congratulations! Likely you got a real raise, not just a cost of living adjustment!
Bonus Question: Ok, what else did they do?
Earned Income Credit
The Earned Income Tax Credit helps some low and moderate income taxpayers reduce their tax bill or increase their income.
For the 2023 tax year, the EITC tax credit ranges from $600 to $7,430 (up $495 on the top end) depending on your income and family size. The EIC total phaseout income for 2023 is:
$17,640 for filers with no children
$46,560 for filers with one child
$52,918 for filers with two children
$56,838 for filers with three or more children
Non-Profit Gift Limits
Anyone who makes donations to non-profits (or works at a non-profit) knows that any gifts that you receive in exchange for your donation must be subtracted from the tax deductible amount of the donation unless they are considered of “insubstantial fair market value”. For the year 2023, these “low cost articles” are those whose fair market value is not more than two percent of the donor’s payment or $125, (whichever is less). Alternately, when the payment is at least $62.50 and the only benefits received are token items (think mugs, calendars, pens, etc., with organization’s name/ logo). These are deemed to be “low cost articles” if their cost does not exceed $12.50. (Remember, this is adding up everything you donate to and receive from an organization over the whole year.)
Student Loan Interest
Starting in 2023, the $2,500 maximum deduction for interest paid on qualified student loans begins to phase out under for taxpayers with modified adjusted gross income higher than $75,000 ($155,000 for joint returns), and is completely phased out for those with a modified adjusted gross income of $90,000 or more ($185,000 for joint returns).
Estate Taxes and Gifts (previously on…)
Anyone passing during 2023, their estate will have have a basic exclusion amount of $12,920,000, up from $12,060,000 for estates in 2022. (Which you might remember from our newsletter deep dive this past September!!) The annual exclusion for gifts increases to $17,000.
Medical Savings Accounts (previously on…)
To qualify for a Health Savings Account, you must have a High Deductible Health Plan. (Subscribers to our newsletter totally know what we’re talking about here!) For tax year 2023, an individual HDHP insurance plan must have an annual deductible no less than $2,650, but no more than $3,950, with maximum out-of-pocket expense amount of $5,300. For family HDHP coverage, the annual deductible is not less than $5,300, not more than $7,900, with the max out-of-pocket expense limit being $9,650.
This all sounds like a lot?
It can be, but for some of us, this stuff is fascinating! Here at Thrive our accountants take pride in making sure that your business is in order, you avoid penalties, and you save as much as you can during tax season. If you want in on our personal or business tax services, let us know! You can find more information and set up a meeting to talk about how we can help you Thrive here: https://www.thriveacct.com/taxes
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