Now that the Inflation Reduction Act has been signed into law, let’s take a quick look at the provisions that affect the personal financial planning process.
Inflation
Will the Inflation Reduction Act bring inflation down? I’m not sure, but would guess nothing changes in the near term.
The Inflation Reduction Act purports to reduce inflation in three ways:
- Reducing the federal deficit
- Providing incentives to increase production of renewable energy goods
- Lowering the cost of prescription medication
The truth is, nobody can predict the net effect of these provisions on inflation and the broader economy. Economies are known as complex adaptive systems and act much like a living organism. At the end of the day, it’s very hard to predict how these sorts of systems will respond to government action.
Medical Expenses
The Inflation Reduction Act provides meaningful relief to Medicare recipients when it comes to prescription drug costs. Here are the main changes:
- The federal government can negotiate prices for certain drugs
- Eliminate 5% catastrophic coverage coinsurance in Part D (staring in 2024)
- $2,000 cap on out-of-pocket spending for Part D (starting in 2025)
- Limits copay for insulin to $35/month for Part D (starting in 2023)
Previously set to expire in 2022, the enhanced subsidies for health insurance through the Affordable Care Act (ACA) were extended through 2025. The enhanced subsidies allow somewhat higher earners to take advantage of ACA marketplace plans. Under the original ACA subsidies, you lost any benefits as soon as your income exceeded 400% of the federal poverty limit.
One potential downside… the lower drug costs in Medicare could lead to higher prices for those on private insurance.
IRS Funding
As part of the Inflation Reduction Act, the IRS will receive a big boost in funding. The funding should help the IRS reduce the Tax Gap and improve customer service.
If you are a small business owner, it’s reasonable to expect a higher risk of audit in future years. The risk of audit applies both on the income tax side, as well as to any employee benefit plans sponsored by the business such as a 401(k) plan.
On the plus side, it’s likely that dealing with the IRS will become much easier in the near future as they add staff to handle taxpayer issues.
Clean Energy Tax Credits
The Inflation Reduction Act also tweaks the tax credits for clean energy goods such as electric vehicles.
Under the old rules, the $7,500 tax credit for electric vehicles was phased out based on how many vehicles a manufacturer had sold in the market.
For example, if you bought a Tesla today, you would not be eligible for a tax credit. But if you bought an electric Kia, then you would get a tax credit. The only difference is Tesla has sold enough vehicles to exceed the limits set by the government, but Kia has not. The old rules were intended to help a manufacturer get up to speed in the electric car market and then taper off over time.
The Inflation Reduction Act removes these unit production limits and replaces them with a new regime of rules that incentivize car manufacturers to build the vehicles and batteries within North America. Currently, no manufacturers meet these new rules, but it’s likely the regulators will suspend them for a few years to give the car industry time to build up their domestic supply chains.
New Corporate Taxes
To pay for everything and reduce the federal deficit, the Inflation Reduction Act includes new corporate taxes.
First, companies earning more than $1 billion will pay a new 15% minimum tax. This tax will be levied on book income instead of taxable income.
Companies will also pay a 1% excise tax on any share buybacks.
The excise tax on share buybacks presents an interesting development for investment planning. Companies generally have two methods to return cash to their investors: dividends or buybacks. By disfavoring buybacks in relation to dividends, it’s possible that companies will increase their use dividends.
From the standpoint of the individual investor, this is sub-optimal. Anyone who has read Warren Buffet’s writing knows that buybacks generally give the individual investor more control over the timing of taxable income.
Dividend checks arrive based on the schedule set by the company (usually every quarter). The individual has no control over when they arrive. They simply report the total amount on their tax return and pay the taxes due.
When buying back shares, a company goes to the market and buys the shares. This leaves the choice of timing up to the individual shareholder. If Tommy needs cash, he can sell his shares in the market and realize any capital gains/taxable income. But if Suzy doesn’t need cash right now, she keeps her shares and incurs no taxable income. Her taxes are deferred until whenever she chooses to sell her shares (or eliminated at her death).
The new excise tax will act as a disincentive to doing buybacks. We will have to wait and see whether companies will increase dividends to compensate, or choose to retain a larger portion of their earnings and invest those funds inside the business.
