High inflation has led state and federal authorities to make more dramatic alterations than usual to income tax brackets for the coming year.
Both the U.S. and Minnesota tax agencies have pushed up the floor for the brackets that determine the rate at which wages and other personal earnings get taxed. In response to the highest inflation in decades, the bracket adjustments are large — more than 7 percent compared with bumps of 1 percent to 3 percent in recent years.
“It's the highest adjustment we've made since probably the early 80s,” said Eric Willette, research director at the Minnesota Department of Revenue.
The annual exercise typically doesn’t get much notice, other than from tax professionals. But the size makes this one different because not going to this extent could have meant a sting for filers later.
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Total wage income in Minnesota increased by 7.2 percent in 2021 and was on course to be 6.9 percent higher this year, according to the state’s updated economic forecast. For next year, the annualized bump is likely to recede to 4.5 percent.
“As people's income grows over time for inflation, more of their income would be in the higher brackets. Oftentimes ‘bracket creep’ is the term that's used for this phenomenon. And it was the reason for creating the indexing law in the first place,” Willette said.
Without the automatic annual review and adjustment, Minnesota lawmakers would have to pass a new bill each year.
Due to the graduated tax system in place, the revised brackets means a greater amount of income will be taxed at lower rates.
For people whose pay remains static, that could reduce tax liability and drop what they ultimately owe in taxes. But for people seeing big raises, merit pay or other income bumps, it could be a wash.
“You definitely need to look at it on a case-by-case basis,” said certified public accountant Steve Warren of the firm Schecter Dokken Kanter. He said in most years the adjustments suit a “goal of government, which is “to try to adjust brackets so you're paying roughly the same tax on roughly the same amount of buying power in pay that you have from year to year.”
For example, a married couple filing jointly will have up to $174,610 of their taxable income fall into the first or second tax brackets in 2023. The first quarter of that income is taxed at a rate of 5.35 percent; the rest at 6.8 percent.
Currently, that same family would be bumped into a higher tax bracket on earnings above $163,060.
Minnesota’s third tax bracket assesses a 7.85 percent tax on income in that segment. The fourth and highest tax rate is 9.85 percent.
Standard deductions and dependent exemptions will also rise. The standard deduction will be $13,825 for single filers and $27,650 for married joint filers. The dependent exemption is increasing to $4,800 from $4,450 now.
So what should taxpayers do to account for it?
“The goal of these bracket changes is to make it so most people don't need to do anything,” Warren said, cautioning against quick moves to adjust withholdings.
He added, “But you always have to look at it on an individual basis. Some people have other changes: merit pay, increase, change in hours, added second job, investment portfolio income changes. All of those things matter for determining how much you should be paying into the government in taxes.”
The bracket adjustments do have an impact on Minnesota’s anticipated revenue into the future. According to a budget forecast released this week, tax liability is lowered by $100 million in fiscal year 2024 and $318 million for the year after.
The Federal Reserve has tried to get inflation back in check by raising interest rates, which increase the costs associated with car loans, mortgage rates for home purchases and credit card finance charges.
But it also is advantageous for people and entities with bank savings.
While services and goods that Minnesota’s government provides have become more expensive, the state is likely to reap millions of dollars on the money it has stashed away.
The state’s rainy-day reserve has hit a record high of $2.85 billion and a cash-flow account of $350 million is accruing interest, too.
State Economist Laura Kalambokidis said all of Minnesota’s investment income will be about $165 million for the budget that runs through this summer and $700 million more for the two years that follow.