Can You Still Pay Alimony and Save on Taxes?
For decades, alimony, also known as spousal support, was taxable as income to the recipient, and deductible to the person paying. That makes a certain amount of instinctive sense: the spousal support recipient gets the benefit of the money, so why shouldn’t they also have the burden of paying income tax on it? That rule also served as an incentive for an ex-spouse with higher income to pay spousal support. Because they were able to deduct the amount of the support from their own taxable income, their own taxes would be lowered and they might even fall into a lower tax bracket.
It sounds like a win-win, and in many ways it was. But with the advent of the Tax Cuts and Jobs Act (TCJA), the major tax reform that the federal government enacted in 2017, the rules were changed. As of January 1, 2019, if spousal support was awarded in a divorce, the person paying it also pays income tax on those funds, which are tax-free income to the recipient.
That might seem unfair to a person paying. What was the reason for the change, and what are the effects? And is there any way to offer a lower-earning spouse needed support, without imposing a tax burden on a higher-earning one?
How the TCJA Changed the Tax Rules for Spousal Support
If your divorce was final before January 1, 2019, the old tax rules apply to your spousal support payment. However, if you were divorced before December 31, 2018, and you move to modify your spousal support award after January 1, 2019, your modification order may be subject to the new tax rules. That means that for people paying spousal support, it may not be worth it to pursue a small downward change in payment, if it will be offset by an increase in taxes.
While the new tax rules around alimony may be bad news for people paying spousal support (and more income tax on top of it) they are good news for the federal government’s coffers. People paying spousal support are often in a higher tax bracket than those receiving it, and alimony payments will now be taxed at a higher rate.
Option for Spousal Support and Tax Savings Post-TCJA
An unfortunate side effect of the loss of the deduction for paying spousal support is that some spouses will be less willing to offer alimony in a settlement. If it is offered at all, the paying spouse may be less willing to pay a higher amount. If the other spouse needs the post-divorce financial support, an impasse over spousal support could cause settlement negotiations to grind to a halt. This, in turn, could drag out divorce proceedings, costing both parties more money.
Fortunately, there is at least one option to blunt the effect of the new tax rules. Higher-earning spouses may no longer be able to deduct payments of spousal support on their income tax returns, but a spouse may be able to transfer funds from their retirement account instead.
Here’s how it works: a spouse who makes payments through an Individual Retirement Account (IRA) would have had to pay money on a withdrawal from that account if withdrawn for their own use. When the recipient, who otherwise would have received those funds as alimony, withdraws them instead, they are the person to pay income tax on the money. This mimics tax consequences of spousal support under the old rules.
There are some limitations on this option. First, the spouse receiving the payment from the IRA would need to be at least 59 ½ years of age, or they will face a 10% penalty on the funds withdrawn, on top of the taxes they would owe. Second, a transfer of funds from an IRA would be a one-time occurrence, rather than monthly payments, which might make budgeting more difficult. One possibility would be to take a smaller monthly payment of spousal support along with a reduced lump sum from the IRA. The arrangement of a lump sum payment from an IRA would need to be clearly spelled out in the divorce settlement.
If you hope to receive spousal support, your attorney may refer you to a certified financial planner (CFP) to discuss this option. If you expect to pay spousal support, you may want to talk to a CFP before offering a payment from your retirement account, to ensure your own financial security in retirement will not be jeopardized.
If you have questions about spousal support and taxes, or ways to maximize your financial health after divorce while minimizing your tax burden, we invite you to contact Fremstad Law to schedule a consultation with one of our experienced family law attorneys.