Divorces are difficult, but add to them the stress of trying to understand tax law, and the road ahead looks even darker. One bright spot in the pre-2018 tax laws was that a tax benefit existed in cases involving alimony. Under the IRS tax rules before 2018, alimony was tax deductible to the payor, while being taxable to the recipient. But this has changed under the most sweeping federal tax code overhaul in decades, the Tax Cuts and Jobs Act of 2017 (TCJA).
Alimony and Taxes
In instances where there is a sufficient difference in the income of divorcing spouses, alimony may be a part of a negotiated settlement or ordered by a court. Where a high-income earner is paying alimony, they are usually in a higher tax bracket, so the tax deductibility of the alimony can save the payor – and even the family unit as a whole – a significant amount of money. This savings is sometimes so important that parties with potential alimony payments will build all other financial aspects of the divorce around alimony and calculate which scenario will give the best tax break or keep the most money in the family.
For example, suppose William pays Mary $5,000 per month in alimony. Mary doesn’t get to keep $5,000 because it’s treated as taxable income to her. Based on her 25% tax bracket, Mary’s actual monthly net is $3,750. Conversely, as William is in a higher, 40%, tax bracket, when he writes a check to Mary for $5,000, the deduction translates to an out-of-pocket cost to him of $3,000.
In practical terms, taxable alimony shifts income from a high tax bracket to a lower one. Uncle Sam has been footing the bill on the $750 differential in tax revenue between the $3,750 that Mary nets and the $3,000 that it costs William. That is exactly what the new regulation in the TCJA is structured to eliminate.
The New Tax Law and Alimony
The TCJA does away with the tax deduction for alimony. Even though the recipient would take the alimony tax free, the total tax bill per family will go up. The payor would pay alimony with post-tax dollars and would no longer have the benefit of that alimony tax deduction. While the recipient’s net income would appear to increase, the higher tax payment overall for the family, in turn, will likely lead to lower alimony orders.
Of course, such concerns presume that parties won’t act collaboratively to obtain and share the best net tax outcome for their families.
Timing is Critical
The new law’s treatment of alimony applies only to spousal support paid under a divorce instrument executed after December 31, 2018 and doesn’t apply to alimony agreements entered before that. This means that people divorced prior to December 31, 2018 will continue to have their alimony payments deductible to the payor and taxable to the recipient. Meanwhile, those divorced after December 31, 2018 will not get that benefit.
Thus, it is critical that parties contemplating divorce, family law practitioners counseling them, and mediators assisting them understand the changing law and can intelligently weigh the risks and benefits of negotiating and filing for divorce in 2018, while the deductibility and taxability of alimony remains in effect.
Although couples may think they have until year-end before they need to worry about the changes, in Massachusetts, once a divorce is finalized by approval of a Joint Petition for Divorce by a Judge, there is still a 120-day waiting period before the divorce is final. Therefore, the latest day you can have a hearing on a Joint Petition in Massachusetts to take advantage of tax deductible alimony is Friday, August 31, 2018.
Mediate Your Divorce
Finally, before you file for divorce, consider out-of-court dispute resolution before resorting to litigation. Mediation is a voluntary process that gives you and your spouse control over your divorce and its terms. Mediation allows you to privately discuss all aspects of your divorce, go over different options, and decide what is best for you and your family. Armed with the knowledge gained from discussion, you can easily write terms that work for you and give you flexibility when and where you want it.
If you or someone you know could benefit from assistance in decision making during a divorce, contact Falmouth Mediation at 508-566-4159 for a free, no-obligation, private, confidential consultation. We will be happy to discuss the key details of your situation, address any concerns, and help you decide if divorce mediation would be beneficial.
July 16, 2018 UPDATE
Recently, a client's attorney advised him that, contrary to my writing that the latest day you can have a hearing on a Joint Petition in Massachusetts to take advantage of tax deductible alimony is Friday, August 31, 2018, "only the judge's signature is required before the December 31, 2018 deadline, and the waiting period could roll into 2019 without affecting the tax deductible alimony payments."
I believe that the confusion, if you will, is because the IRS has not issued specific guidance on how they are going to interpret the language of the Tax Cuts and Jobs Act of 2017, specifically the language around alimony.
The law says “ … divorce or separation instruments that are executed after December 31, 2018.” Fellow mediators and financial planners that I know and trust have interpreted “executed” as meaning “come into legal existence due to a court order.” Thus, because of the waiting period in Massachusetts (which, by the way, differs from state to state) they have counseled that the divorce must be final by December 31, which means signed by a judge by August 31.
In the absence of guidance from the IRA I am taking a conservative approach in that I would much prefer to be positive that decisions my clients make will hold up to an IRS decision than to hope that they will.