Inflation will affect tax brackets

This article appears in the November 2022 issue of Advisor’s Edge magazine — our second last print issue. If you’re a print-only subscriber, learn more about our digital transition and how to continue to receive all the best news and features on Advisor.ca.

Inflation has affected almost every aspect of our financial lives — and it affects our taxes as well.

Federally, and in most cases provincially, our tax brackets increase with inflation on an annual basis. This is a good thing. (Alberta de-indexed its tax brackets in 2019 but will resume indexing for the 2022 tax year. A recent study by the University of Calgary’s School of Public Policy said the de-indexing move effectively forced Albertans to pay almost $647 million more in taxes from 2020 to 2022.)

Consider a simplified situation involving Joe, who earns $50,000 per year. His wages increase annually by inflation, which we’ll say is 5%. We assume there are only two federal tax brackets and a $14,000 basic personal amount (BPA). The first tax bracket is 15% on the first $50,000 of income and the second is 20.5% on income over $50,000 up to $100,000. Currently, Joe’s income taxes total $5,400: 15% of $50,000 minus $2,100 (15% of $14,000 BPA).

Next year, Joe’s income increases by 5% to $52,500 (see Table 1).

Table 1: Tax brackets with and without inflation indexing

When the tax brackets increase with inflation, Joe’s marginal tax rate (MTR) remains at 15% and his taxes increase to $5,670. This is expected because his taxable income also increased. So, in real terms (adjusted for inflation), both his income and his tax bracket are the same. Even the BPA is indexed. In Joe’s case, this results in his after-tax income growing by the 5% inflation rate (from $44,600 to $46,830).

But if tax brackets aren’t indexed to inflation, Joe experiences tax-bracket creep. First, his MTR increases to 20.5%, because $2,500 of his $52,500 of income now falls in the second tax bracket. Second, the higher MTR increases his effective tax rate (ETR). This is further increased by the BPA not increasing by inflation. In the previous year, Joe’s ETR was 10.8%; now it’s 11.26%.

The result for Joe is that, despite his pre-tax income increasing with inflation, his after-tax income doesn’t. In this case, his net income is $46,588 — 4.46% higher than the previous year. After tax, Joe experienced a loss of purchasing power.

In short, failing to index tax brackets, credits and deductions to inflation has the same effect as a tax increase. That’s why indexing in our tax system is a good thing. But not all amounts are indexed (e.g., the child-care expenses deduction and the federal pension income amount).

Reduce the pain

Clients may also experience tax bracket creep when their income increases from one bracket to another. This can occur due to a raise or working overtime. Retirees can have a similar experience when their taxable income changes. You can help clients with two tried and true planning strategies.

RRSP contributions are an obvious first way to help reduce taxable income. Recall that Joe’s MTR increased to 20.5% when tax brackets didn’t increase annually and that $2,500 of his income fell into a higher tax bracket. If Joe made a $2,500 RRSP contribution, the associated deduction would result in tax savings at 20.5%. This would have put his taxable income back to the original $50,000 — and his taxes, along with his MTR and ETR, would have returned to their original amounts.

Second, consider restructuring taxable investment income for retirees. For example, interest income is reported at 100% of the actual amount, whereas capital gains are reported at just 50%. Restructuring a portfolio to include income with lower inclusion rates can help retirees reduce their taxable income without necessarily reducing cash flow. Depending on the client, you may even be able to increase their after-tax income while lowering both their taxes and taxable income.

Curtis Davis, FCSI, CFP, TEP, is director for tax, retirement and estate planning services, retail markets at Manulife Investment Management

Curtis Davis

Tax & Estate

Curtis Davis, FCSI, CFP, TEP, is director for tax, retirement and estate planning services, retail markets at Manulife Investment Management.