Unlike many changes to the tax laws which are effective for only limited periods of time, indexing has become a settled part of the tax code, according to George Jones, JD, CCH senior tax analyst.

"While some tax cuts in recent years are only temporary, and are scheduled to be followed by increases down the line, indexing works year after year, and it's likely to be a part of the tax laws for the foreseeable future irrespective of whether Congress plans to tinker more with the tax rates themselves," Jones said.

Indexing of brackets lowers tax bills by including more of people's incomes in lower brackets -- in the 15-percent rather than the 25-percent bracket, for example.

"This also means that across-the-board inflation adjustments to the brackets provide more relief for those in the upper brackets, since they share in the reduction within each bracket, not just their own marginal tax bracket," Jones noted.

Two examples show the modest tax savings generated by indexing:

• Because of inflation adjustments, a married couple filing jointly with a total taxable income of $100,000 will pay $267.50 less in income taxes in 2007 than they will on the same income for 2006.  
• A single filer with taxable income of $50,000 will save $131.25 next year due to the adjustments.

Inflation adjustments

Since the late 1980s, the U.S. tax code has required that federal income tax brackets be adjusted for inflation annually, and inflation adjustments have been inserted into the Internal Revenue Code in recent years with increasing frequency. For example, the Code now requires over 50 other inflation-driven computations to determine deduction, exemption and exclusion amounts in addition to the 40 separate computations needed to inflation-adjust the tax bracket tables each year. Tax legislation in 2006 continued to add to the number of required inflation adjustments.

The adjustments are based on Consumer Price Index figures for September through August immediately prior to the adjusted year.  CCH’s projections are based on the relevant inflation data released September 15, 2006, by the U.S. Department of Labor.

The IRS usually releases official numbers by December each year.  CCH tax bracket projections are provided for illustrative purposes only, and should not be used for income tax returns or other federal income tax related purposes until confirmed by the IRS later this year.

Some items not indexed

Jones observed that some items in the Code are not indexed for inflation and stay the same, while others rise by dollar amounts already written into the tax law.

"The exemption amounts for the alternative minimum tax are not indexed, which means that each year Congress must either increase the amounts by statute or expose additional households to the alternative tax," Jones said.

By contrast, the adjusted gross income limits on the ability to make full contributions to Roth IRAs have been established by law at the $95,000 level for singles and $150,000 for joint filers since 1998. Now they have been made inflation-sensitive through 2006 legislation. For 2007, the AGI phase-out levels rise to $99,000 and $156,000, respectively.

Standard deduction, personal exemption also rise

The standard deduction and personal exemption amounts are also subject to indexing and these are projected to increase for 2007. These increases can produce lower taxes by reducing the taxpayer's taxable income.

Single taxpayers and married taxpayers filing separately could see a $200 increase over 2006 in their standard deduction, to $5,350, while the standard deduction for joint filers will increase by $400 to $10,700. Heads of households will see an increase in their standard deduction of $300, to $7,850.

The additional standard deduction for those age 65 or older or who are blind, which did not rise in 2006 from the year before, will take a $50 jump in 2007 to $1,050 for married individuals and surviving spouses, and $1,300 for single filers. The personal exemption amount will go up in 2007 by $100 to $3,400.

These inflation adjustments can add up over time. For example, since the 1987 tax year, the standard deduction for joint filers has increased more than two-and-a-half times, from $3,780 to the anticipated $10,700 amount for 2007.

Taxpayers can, however, lose a good portion of the value of personal exemptions and itemized deductions when their incomes rise above certain levels.  Those "phaseout" levels are also adjusted for inflation. For 2007, married couples filing jointly will begin to lose some of the value of any itemized deductions when their adjusted gross income exceeds $156,400. Likewise, they will begin to lose some of the value of their personal exemptions when their adjusted gross income exceeds $234,600.  However, some relief from this "stealth tax" is kicking in, beginning with this tax year.

In 2006 and 2007, the reduction in personal exemptions and itemized deductions is scheduled to be only two-thirds of what it was in 2005. That’s because both "phaseouts," first started under the Revenue Reconciliation Act of 1990, are themselves now scheduled to be phased out by one-third in 2006 and 2007, two-thirds in 2008 and 2009 and completely repealed for 2010. For a complete look at how income ranges for each tax bracket are projected to shift next, see the attached CCH chart.

"Kiddie" deduction, gift tax exemption

In general, inflation adjustments are rounded to the next-lower multiple of $50, so if the adjustment produces an increase of less than $50, no increase is made.  The "kiddie" standard deduction, used on the returns of children who are claimed as dependents on their parents’ returns increased in 2001, from $700 to $750, and jumped next to $800 for 2004.  For 2006, it increased to $850, where it will remain for 2007.

The tax code only allows the gift tax exemption to rise when the inflation adjustment would produce an increase of $1,000 or more. The last increase occurred at the beginning of 2006, when the exemption increased to its current $12,000. This year’s inflation figures aren’t enough to push it over the next threshold, so it will stay at $12,000 for 2007.