Critics have long framed tax refunds in a less-than-flattering light, saying they’re merely the Internal Revenue Service repaying an interest-free loan to people who overpaid the taxman throughout the year. This year, there’s an additional reason to stay sober about refunds — and it stems from how the tax code deals with the rising cost of living.
Tax-refund amounts this tax season are nearly 5% higher than they were at this time last year, averaging $ 3,050 as of late March, according to the latest IRS data.
There were no major tax-law changes in 2023 that would have pushed up this year’s refund amounts in the aggregate, despite attempts to make the child tax credit more generous for low-income families. But there were year-over-year adjustments to approximately 60 inflation-indexed tax-code provisions, including the ranges for the seven income-tax brackets and the widely used standard deduction, which reduces taxable income.
From the archives (November 2023): IRS announces 2024 income-tax brackets: Here’s what they mean for your tax bill
The roughly 7% increase in tax brackets and the standard deduction for 2023 returns was a result of 2022’s red-hot inflation, marking the biggest single-year adjustment in decades, by one measure. And those adjustments for 2023 may have outrun wage gains for many taxpayers, subjecting slightly less of their money to taxation and leaving more of it to become refund cash, some tax experts say.
In other words, the IRS’s progressively higher tax rates are kicking in at higher income levels for 2023, and the bigger standard deduction is helping people reduce more of their taxable income than they could previously. So if a wage stayed relatively constant from 2022 to 2023, the tax-code lift exposes less of it to taxes — and could create a bigger refund for that taxpayer.
This serves as another reminder, experts add, that pay increases haven’t fully kept up with the rising cost of living for many people.
To be sure, major life events over a year — like a new child, income from a new job, investment moves or green-energy home renovations — can impact how much the IRS owes a taxpayer, or vice versa.
Still, inflation adjustments account for “the lion’s share” of the reason many people are getting bigger refunds when there’s no other life event to explain the change, said Mark Steber, the chief tax information officer at Jackson Hewitt.
“More money coming back means you’re generally not keeping pace with inflation,” Steber said. “If your refund went up, and your information didn’t change at all … are you really doing better?”
Larger refund checks, but fewer of them
Beth Kilday’s combined state and federal refund of $ 1,276 was more than three times the size of her total refund last year. The Palmer, Neb., resident typically prefers to tuck away pretax money in interest-bearing accounts throughout the year, she said, and get a small tax refund.
While last year’s income from her family ranch was down, she received a roughly $ 1,500 cost-of-living pay bump from the school district where she works as a special-education teacher.
This year’s larger-than-expected refund was “a happy surprise” at first, Kilday said. “But when you think about it, I shouldn’t have had that big a refund.”
After hearing from her tax preparer, Kilday called her school district’s offices to check if any payroll-withholding changes explained the larger refund. “They said it was because of the new tax changes. … ‘You’re not the only one who called in and wanted to know what happened,’” she recalled hearing.
While the IRS is writing larger refund checks, it’s cutting fewer of them this year. So far, it has issued 2 million fewer refunds than last year.
At Jackson Hewitt, Steber is seeing more people facing a balance due compared to last year because of factors like no tax withholding on extra gig work or a tax bill after investment profits.
“If you owed money, are you really doing worse?” he said. Effective tax rate — or the percent of annual income someone pays in taxes — is a better measure of a person’s tax obligations than their refund amount or balance due, he added.
There’s no single pattern that explains what’s happening with refunds and taxes owed this season, said Tom O’Saben, the director of tax content and government relations at the National Association of Tax Professionals.
In his own practice, O’Saben is seeing higher refunds for people whose tax situations remained relatively unchanged year over year. But he’s also seeing smaller refunds and balances due for people whose investment gains and interest income boosted tax bills.
The range of outcomes this year reflects the varying economic forces affecting wallets and portfolios, including high living costs and high interest rates, he said.
Playing catch-up
After U.S. inflation reached a four-decade high in the summer of 2022, price increases eased slightly, albeit unevenly, last year. 2023 started with an annualized inflation rate of 6.4% in January 2023 and ended at 3.4% in December 2023, according to the Bureau of Labor Statistics. By February of this year, the yearly rate of inflation had receded to 3.2%.
March’s inflation numbers came in hotter than expected on Wednesday.
To be sure, many workers have certainly seen wage gains as they contended with higher costs. That has especially been the case for lower-income households.
Related: The lowest-paid U.S. workers are seeing their wages surge faster than any other group of earners
In fact, the inflation-adjusted costs that employers incurred on wages, salaries and benefits outpaced inflation by 0.9% in 2023, according to the Bureau of Labor Statistics’ employment-cost index. Nominal wages grew by a median 5.2% over the course of 2023, according to the Federal Reserve Bank of Atlanta. Its wage tracker monitors workers’ wage growth observed 12 months apart using a three-month moving average.
But did the size of a person’s 2023 income gains outrun the big-time 7% jumps for tax brackets and the standard deduction?
The yearly changes try to minimize “bracket creep,” a term that refers to people stumbling into higher tax brackets on nominally higher wages but lacking the spending power to afford the higher rate. This diminishes the boost of a raise compared to the drag of inflation plus taxes.
The IRS adjustments for tax year 2023 lag behind the conditions in which people are now filing their taxes, said Garrett Watson, a senior policy analyst and modeling manager at the Tax Foundation. Those changes were fueled by 2022’s inflation numbers, and Americans are wrapping up their returns in early 2024, he noted.
This year’s relatively higher refund amounts could finally reflect the outsize adjustments, Watson said. “I think it’s fair to say it might be catching up,” he said, though determining the exact impact is tougher.
People who know they have a refund coming typically file sooner, and that can skew the average, Watson added. “It’s hard to judge how much of this is noise.”
Paycheck withholding is designed to skim off a percentage of pay, no matter the size of the base pay. If people tweaked their paycheck withholdings last year to hold back more for taxes, they could conceivably receive larger tax refunds as a result.
But workers generally do not alter their paycheck withholdings after setting them at the start of a job, said Michael Trabold, the director of compliance at Paychex PAYX, -2.17%, which provides payroll services to companies. “It’s very much ‘set it and don’t think about it,’” he said.
The inflation adjustment “probably isn’t the whole reason” for larger refunds, but “it’s certainly a contributory factor,” Trabold said.
In a study of employers that use Paychex as a vendor, the company analyzed the withholding patterns of people who switched jobs between such companies last year. Job switchers tended to divert less of their pretax income and keep more in their paycheck, the data showed.
Inflation may have seeped into Kilday’s tax return, and it surely crosses her mind at the grocery store. But the Nebraska special-education teacher’s small-refund attitude is propelled by another sign of times: the high interest rates for savers.
Now that her refund numbers have sunk in, she is thinking differently about future tax strategies. “It’s not the greatest feeling, because I could have put that away in a money-market or a savings account or an IRA,” she said.
Did you get a bigger refund this year? We want to hear from readers who have stories to share about the effects of increasing costs and a changing economy. If you’d like to share your experience, write to readerstories@marketwatch.com. A reporter may be in touch.