Adjusting Your Taxes For Inflation

The IRA (Independent Retirement Account) was established by Congress in 1974 with a $2,000 annual contribution limit. It was increased to $5,000 in 2001 by the Republican Congress and then indexed for inflation. It is an extra $1,000 per year for those over age 50. Since inflation has increased prices by about 6 fold since 1974 then then the IRA annual contribution limit should be about $12,000 to be fair about inflation. Unfortunately the inflation indexing law only applies since 2001. During the era of 1974-2000 taxpayers were denied tax savings opportunities for a tax-deductible IRA contribution because the tax code was not fully indexed to automatically adjust for inflation. This constituted a massive tax windfall for the government which should have been used to pay down the debt. Instead even more debt was incurred by the government due to spending increases.

The Reagan era tax changes adjusted basic income tax rates to automatically be indexed for inflation but did not adjust specific items such as IRA’s AMT or the basis of Capital Gains.

Alternative Minimum Tax or AMT

The AMT was started in 1969 at an income threshold of approximately $40,000. If adjusted for inflation it would be about nine times bigger or $ 360,000. Imagine how much less tax would be owed if AMT threshold were adjusted for inflation. Basic tax rates are automatically indexed for inflation, but AMT is manually adjusted at the whim of Congress.

Long Term Capital Gains Tax

The rate for long term capital gains tax was 28% during the Reagan administration and about 40% during the 1930-1979 era. But what about adjusting the basis (“basis” is the cost to buy an investment) for inflation? For example, if you bought a stock for $10 in 1965 and sold it today for $100 you would breakeven after adjusting for inflation. If you bought a stock in 1980 for $10 and sold it for $25 today you would breakeven. So a stock purchased for $10 in 1980 and sold today for $25 would be taxed at $15 profit times 15% or $2.25 tax, but there was no real income after adjusting for inflation. So in that case the tax rate was really over 100% since the $2.25 tax was more than the $0 inflation adjusted profit.

The implications of this is that society is taxed enough and any attempt to raise taxes would reduce the purchasing power and self confidence in the private sector of the economy leading to a recession. This implies that the economy will remain stuck in the doldrums of low or receding growth which implies low inflation and declining stock prices.

About the author

Don Martin, CFP®

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