Latest / Inflation and Your Money with Fexingo: Protecting Purchasing Power and Beating Inflation / Why Your Paycheck Buys Less Every Year
Transcript
- Lucas: So you get a raise. Four percent. You're happy, right? But then you look at your paycheck and somehow you're taking home less than you did last year. Luna: That's the worst feeling. It happened to a friend of mine in Austin — she's a software engineer. Got a solid raise, but she got bumped into a higher tax bracket and her rent went up. Net result: she's losing ground. Lucas: Right. And that's exactly the phenomenon we're talking about today: bracket creep. It's a stealth tax increase that happens when inflation pushes nominal wages higher, but the tax brackets don't adjust quickly enough — or accurately enough — to reflect real purchasing power. Luna: Okay, but don't the brackets get adjusted every year? I thought there was something called inflation indexing. Lucas: They do. The IRS adjusts tax brackets annually based on the chained CPI — that's a measure of inflation. For 2025, the brackets were widened by about 3.2 percent. But here's the thing: the CPI data used for that adjustment is from the previous year. And if you look at the latest CPI print — April 2026 came in at 332.4, up from 330.29 — that's about 3.4 percent year-over-year. So the adjustment is lagging by roughly half a percentage point. Luna: So you're saying the bracket adjustment is based on old inflation data, and by the time it's applied, inflation has already eaten away some of the benefit. Lucas: Exactly. And it's worse for people whose costs go up faster than the average CPI. If you're renting in a city where rents are up 6 or 7 percent — which is still happening in many metro areas — your personal inflation rate is way above the official number. So the bracket adjustment doesn't protect you. Luna: But isn't it just a timing issue? Over a few years, doesn't it even out? Lucas: In theory, but in practice, no. Because even if the brackets eventually catch up, you've lost real income in the interim. And if you're getting annual raises that barely keep pace with inflation, you can get stuck in a cycle where your nominal income rises, your tax bill rises, and your real income is flat or declining. This is especially acute for people near the top of a bracket — they get pushed into the next one by just a few thousand dollars. Luna: So what can someone actually do about it? I mean, you can't control the IRS's inflation adjustment schedule. Lucas: You can't change the brackets, but you can manage your taxable income. One classic move: max out your pre-tax retirement contributions — 401k, traditional IRA. That lowers your adjusted gross income and can keep you in a lower bracket. Another option: if you expect to be in a higher bracket in retirement, converting some traditional IRA money to a Roth now, while you're still in a lower bracket, can make sense. Luna: That's a bet on future tax rates, though. Not everyone's comfortable with that. Lucas: True. But there's a lower-risk play: municipal bonds. The interest is exempt from federal income tax, and often state tax too. If you're in a higher bracket, the tax-equivalent yield can be very competitive with taxable bonds. It's not a growth play, but it can preserve purchasing power after tax. Luna: So you're saying bracket creep is essentially a hidden tax on people who are getting raises. Lucas: Exactly. And it's one reason why the 'wage growth' we hear about in the headlines can be misleading. If nominal wages are up 4 percent but inflation is 3.5 percent and bracket creep eats another half percent, your real after-tax wage gain might be zero — or negative. That's the story behind a lot of the frustration people feel even when the economy looks strong. Luna: Let me ask you this — does bracket creep affect everyone equally, or is it worse for certain income levels? Lucas: It's worse for people in the middle and upper-middle brackets — the 22 percent and 24 percent brackets. If you're in the lowest bracket, you probably won't get pushed up because the bracket is very wide relative to income. If you're in the top bracket, you're already there. But the 22 and 24 percent brackets are narrow enough that a few thousand dollars of inflation-driven income can push you over the edge. Luna: So basically, the people who are most affected are the ones who are already struggling with rising costs — teachers, mid-level managers, small business owners. Lucas: Exactly. And that's why I think it's worth paying attention to. It's not a crisis, but it's a slow drain. And the tools to fix it — like the ones we just mentioned — are available to almost anyone with a little planning. Luna: Yeah, totally agree. And speaking of that, if this episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. Lucas: Yeah, that's the link. It's what keeps these conversations going. Even a couple of dollars a month makes a difference. Luna: Okay, so back to bracket creep — one thing I've been wondering: does the government actually benefit from this? I mean, they must know it's happening. Lucas: They definitely know. The Congressional Budget Office has estimated that bracket creep adds billions to federal revenue each year. It's essentially a hidden tax increase that doesn't require a vote. And while politicians occasionally propose to index brackets more aggressively, it rarely goes anywhere because it's politically convenient to let it happen quietly. Luna: So it's a feature, not a bug. Lucas: Exactly. And that's why individuals need to be proactive. The system isn't going to fix itself. If you're getting raises, check what bracket you're in. Use a tax calculator to see if a raise actually increases your after-tax income. And if it doesn't, consider adjusting your withholding or making additional pre-tax contributions. Luna: Let's talk about the Austin software engineer example. She got a 4 percent raise, but she said her take-home pay went down. How does that work exactly? Lucas: So she was in the 22 percent bracket. Her raise pushed her into the 24 percent bracket. But only the income above the threshold is taxed at the higher rate. So the first few thousand dollars of her raise were still at 22 percent. But the larger issue is that her rent went up 6 percent, and her health insurance premiums went up, and her state taxes — Texas has no income tax, but property taxes are high. So the combination of higher marginal rate and higher living costs wiped out the raise. Luna: So it's not just the bracket. It's the whole cost structure. Lucas: Right. And that's the real takeaway: bracket creep is one piece of a larger puzzle. You have to look at your total financial picture. But the bracket piece is the one that's most within your control to mitigate. Luna: Okay, so let's say I'm a listener who's worried about this. What's the first concrete step I should take? Lucas: Look at your most recent pay stub and your W-2 from last year. Figure out your marginal tax bracket. Then check the IRS inflation-adjusted brackets for 2025 — they're published online. Compare where you are to the top of your bracket. If you're within, say, $5,000 of the next bracket, and you expect a raise, you might want to increase your 401k contribution or contribute to a traditional IRA to stay under the threshold. Luna: That's practical. And for people who are already in the next bracket? Lucas: Then you want to focus on tax-efficient investing — municipal bonds, index funds with low turnover, holding assets for long-term capital gains. And if you're in a high bracket, considering a Roth conversion in a lower-income year. Luna: It feels like there's a lot of nuance here. But the core message is: don't just celebrate a raise. Look at what it does to your net income. Lucas: Exactly. And don't assume that inflation indexing solves the problem. It helps, but it's not perfect. And for many people, the lag and the composition of CPI mean they're still losing ground. The good news is that awareness alone can motivate you to take action. Luna: So next time you get a raise, do the math first. Lucas: Do the math. Or better yet, run a tax projection before you adjust your budget. It might change how you allocate that extra income. Luna: Alright, so let's talk about the big picture. With the Fed keeping rates where they are — the effective fed funds rate is at 3.64 percent — and inflation still above 3 percent, is bracket creep going to get worse before it gets better? Lucas: I think it will persist as long as inflation stays above the bracket adjustment rate. The ten-year breakeven inflation rate is now at 2.39 percent — that's down from 2.44 earlier this month, but it's still above where the bracket adjustment was for 2025. So unless the IRS gets more aggressive with indexing, bracket creep will continue to be a drag on real incomes. Luna: But there's no political will to change it, as you said. Lucas: Exactly. So it's on us to manage it. And honestly, that's a good mindset for any financial challenge: don't wait for the system to fix itself. Look at your own numbers and make adjustments. Luna: That's a great note to end on. Thanks, Lucas. Lucas: Thanks, Luna. See you next time.