Tax Season 2023: Expect smaller refunds, capital-gains bills and higher audit rates

As we head into 2023, millions of American taxpayers will need to adjust their expectations for their tax return.

The stimulus checks are gone. The child tax credit is gone. Childcare and dependent care credits have returned to normal. And the steep losses from the stock market, which fell 20-30% last year, may have a counter-productive impact on many mutual fund investors, even as these funds lost money.

The net result of these combined changes is that most taxpayers will end up with much smaller refunds, and possibly a tax bill in 2023. Some taxpayers "will likely receive a significantly smaller refund compared with the previous tax year," warned the Internal Revenue Service on December 6th of 2022.

Add in the spiking audit rates for higher earners, and many taxpayers could be in for an unpleasant surprise over the next twelve months.

Federal returns are due April 18th of this year. This leaves taxpayers with a 12.5-week window to organize their paperwork and make tax-smart decisions.

Here's a brief summary of what taxpayers should know heading into the 2023 filing season:

Expect Less Than Last Year

The days of the federal government flooding American households with loads of cash and tax credits from the pandemic are over. The $1,400-per-person stimulus checks from 2021 are gone. That means the married couple with three children who received $7,000 from the Federal Government in 2021 will not see that $7,000 tax credit again this year.

Additionally: Families who received $3,600 per dependent under the age of 6 in 2021 will see that number reduced to $2,000 for 2022. Families with dependents older than 6 but under age 18 received $3,000 per child in 2021; for the current tax filing season it's now $2,000 and that credit goes away if the child turned 17 last year.

There was also a drop in the maximum possible child and dependent care credit from $8,000 in 2021 to $2,100 in 2022. Families with 2 children with dependent care expenses could see their tax credits decrease from $15,200 in 2021 to only $6,100 in 2022. Because this is a credit, that would mean a $9,000 difference in tax refunds from last year to this year.

The average refund last year for the 164 million individual taxpayers was $3,176. Expect much less in 2023.

The Positives of Last Year’s Stock Market Losses

The 20-30% losses in the global stock market last year have a potential upside for taxpayers.

Investors who sold their poorly performing stocks or mutual funds, and captured their losses in 2022, may see some tax benefits in 2023. This technique, known as tax-loss harvesting, can be used to offset capital gains from the sale of other profitable positions.

For taxpayers who didn’t have any profitable sales last year, they can use up to $3,000 of their losses to offset total taxable income in 2022. Any losses beyond the $3,000 mark will be carried forward into future years.

The Negatives of Last Year's Stock Market Losses

Because most mutual funds started 2022 flush with highly appreciated assets from the 13-year bull market that started back in 2009, many of the fund managers were forced to sell positions to raise cash to meet fund redemptions as investors headed for the door in 2022.

The sale of these assets inside the fund may have produced a capital gains tax bill that was then pushed out to existing fundholders. The unwelcome outcome from this is that an investor with a losing mutual fund could face a tax bill from that fund.

As an example, Fidelity's Contrafund lost more than 28% last year. This $91 billion fund sent each fundholder their share of a collective dividend totaling 8.48% of the fund's assets. That means that each fundholder will owe capital gains tax on that distribution. When you add in the 3.8% Affordable Care Act levy to the 20% long-term capital gains rate, the capital gains tax now tops out at 23.8%.

If you had $100,000 invested in the Fidelity’s Contrafund at the beginning of last year, you ended the year with $72,000 in that fund, and you got the privilege of receiving a tax bill on $8,500 of income. How do you like them apples!

Audit Rates

Audit rates have steadily declined for years, but that trend shifted dramatically in 2022.

In an IRS publication from last May, the IRS released new data showing that those making between $500,000 and $1 million faced a 0.6% audit rate as of May 1, 2022. That's equivalent to six people out of 1,000. This is double the 0.3% rate those same taxpayers faced as of Sept. 30, 2021.

The audit rate for taxpayers making between $1 million and $5 million also doubled, from 0.6% to 1.3%. For taxpayers making $10 million or more, the rate quadrupled from 2% to 8.7%.

If there is any takeaway from all the changes coming, it’s this: your tax return in 2023 may be significantly different than what was seen the last few years.

To get started on your tax return, call our office or schedule a meeting below.

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