Interest Rates, Inflation, and Your Taxes
The Federal Reserve sometimes raises or lowers interest rates to keep inflation in check. If you’re wondering how this impacts your taxes—you’re in the right place. We’ll explain the connection between interest rate changes and the annual IRS adjustments to account for inflation.
The One Big Beautiful Bill that passed includes permanently extending tax cuts from the Tax Cuts and Jobs Act, including increasing the cap on the amount of state and local or sales tax and property tax (SALT) that you can deduct, makes cuts to energy credits passed under the Inflation Reduction Act, makes changes to taxes on tips and overtime for certain workers, reforms Medicaid, increases the Debt ceiling, and reforms Pell Grants and student loans. Updates to this article are in process. Check our One Big Beautiful Bill article for more information.
The Fed and Interest Rates 101
One of the reasons the Federal Reserve (Fed) raises and lowers interest rates is to keep prices stable. For instance, lower interest rates encourage people and businesses to borrow money to purchase more goods and services. However, this additional spending can trigger higher inflation. So, when the inflation rate starts to creep up (the target annual rate is 2%), the Fed might raise interest rates to curb some of the spending that’s causing higher prices.
On the other hand, when interest rates are high, people and businesses are less likely to borrow money to buy new things. While less spending can keep inflation in check, it can also slow down the overall economy. That’s why the Fed will sometimes lower interest rates to boost spending and stimulate the economy.
IRS Inflation Adjustments for the 2025 Tax Year
So, how do interest rate changes impact your taxes? By raising or lowering the inflation rate – which the IRS uses to adjust tax brackets, certain tax deductions and credits, and other tax-related amounts each year.
For example, suppose there’s a tax credit that you qualify for each year. If the inflation rate is 3%, the credit might be worth $1,000 one year, but $1,030 the next year. That’s because the IRS increased the credit amount by 3% to keep up with inflation ($1,000 x 1.03 = $1,030).
Here are a few of the IRS inflation adjustments for the 2025 tax year.
Higher standard deductions
One of the most significant adjustments is the increase in the Standard Deduction. For single taxpayers, the Standard Deduction goes from $14,600 to $15,750. For married couples filing joint tax returns, the Standard Deduction increased from $29,200 to $31,500. For head-of-household filers, it increased from $21,900 to $23,625. This means a bigger reduction in your taxable income and a bigger refund or less taxes owed.
New tax brackets
The IRS has also adjusted the income thresholds for tax brackets. These changes mean you can make more money and be taxed less.
Earned Income Credit (EIC)
The Earned Income Credit (EIC) provides significant relief for low-to-moderate-income earners. The maximum credit has increased, providing more substantial benefits for millions of taxpayers. This adjustment helps ease the financial burden on working families, making it essential to understand if you qualify for this credit. For tax year 2025, the maximum EIC amount is $8,046 for families with three or more qualifying children, up from $7,830 in 2024.
Retirement contributions
The limits for 401(k) contributions have increased, allowing for more tax-advantaged savings. This is an excellent opportunity to boost your retirement savings and, if you contribute to a traditional 401(k) plan, reduce taxable income. The basic contribution limit for employees who participate in a 401(k) plan increased from $23,000 to $23,500 for 2025. It jumps to $31,000 (up from $30,500) if you’re 50 to 59, or 64 or older, by the end of the year. Plus, beginning in 2025, the maximum contribution amount is $34,750 if you’re 60 to 63 years old.
Flexible Spending Accounts (FSA) and Health Savings Accounts (HSA)
Higher contribution limits for FSAs and HSAs allow for more pre-tax savings on healthcare costs. Utilizing these accounts can effectively lead to significant tax savings and better financial health.
What’s Next?
With these changes in mind, let’s examine some actionable tips for maximizing your benefits and effectively planning for the next tax season.
Maximize deductions
Ensure you’re not paying more on your taxes than you have to. Track deductible expenses such as medical costs, charitable donations, student loan interest payments, and mortgage interest to lower your taxable income. Use apps and tools to track the costs and donations throughout the year to make tax time easier. Staying organized can save you a lot of stress and money when filing your taxes.
Stay informed
Regularly check for updates on tax laws and IRS announcements. Follow trusted financial news sources like the TurboTax blog and the TurboTax newsletter for tailored advice. Staying up to date with breaking tax news and updates you need to know can significantly impact your tax planning and financial strategy.
Plan ahead
Start early with your tax planning. Consider how life events and changes, such as a new job, marriage, moving, or having a baby, might affect your taxes. Planning ensures you can take full advantage of deductions and credits available to you, making the tax filing process smoother and more efficient.
Savvy saver
Make the most of high-yield savings accounts and CDs while interest rates are favorable. Shop around for the best rates. By optimizing where you save your money, you can ensure your savings grow more efficiently and keep pace with inflation.
Boost your retirement savings
Increasing your retirement savings could help secure your future and provide immediate tax advantages. Remember, contributions to these accounts can significantly reduce your taxable income.
In summary, the IRS inflation adjustments for tax year 2025 are good news for you. Understanding these changes and taking proactive steps can maximize your tax benefits and improve your financial health. Stay informed, plan, and make smart financial moves to take advantage of these changes.
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