Under new tax reform, alimony payments for a divorce executed after Dec. 31 of this year will no longer be included in the taxable income of the recipient – and, perhaps more important, will no longer be deductible by the payer.
Currently, a higher-earning ex-spouse who pays alimony to a lower-income ex-spouse gets an ordinary tax deduction and the receiving ex-spouse has taxable ordinary income. Assuming, for instance, a higher-earning ex-spouse has a tax rate around 45 percent and a lower-income ex-spouse has a 25 percent combined rate, $20,000 of alimony per year right now means the higher earner gets a tax deduction of $9,000 and the lower earner pays $5,000 in tax, according to Christopher Wittich, CPA and senior manager with Boyum & Barenscheer in Bloomington, Minn.
“It means that the higher earner spends a net of $11,000 cash, and the lower earner receives $15,000 of net cash. The rub here is that the IRS ends up losing,” Wittich said, “as the deduction for the person paying the alimony is inevitably more than the taxes collected by the IRS from the alimony recipient.”
The Revenue Tax Act of 1942 made alimony deductible to the payer. The new law comes into effect for divorces that occur in 2019.
“Most HNW clients have been asking questions on the changes made to the individual income tax brackets, the loss of the state and local tax deduction and the new deduction for pass-through entity owners. The changes in alimony have been a real sleeper,” said James McGrory, CPA and shareholder with Drucker & Scaccetti in Philadelphia and a member of the Pennsylvania Institute of CPAs.
“I believe that the reason for the change was as a money-raising effort, since usually the payer who gets the deduction currently is in a higher tax bracket than the recipient,” added David George, a CPA/PFS in Irvine, Calif., a past chair of the California Society of CPAs who has worked with HNW clients.
Alimony payments under grandfathered agreements executed before this Dec. 31 will continue to be taxed under the old law. These payments cannot be for child support or property settlements, to maintain property partially owned by the ex-spouse making the payment or for any voluntary maintenance payments.
When rumor of this tax-law change spread last fall, advisors and tax preparers reported rushes of couples who thought the law would take effect in 2018. In a potentially frantic year for breakups, what’s the best advice?
Don’t lie, for one. A recent report revealed discrepancies between alimony claimed as paid by one ex-spouse and claimed as received by the corresponding former spouse. The IRS will look more closely to see if the numbers match.
“If there’s a spread between the tax rate of the higher earner and the lower earner, finalizing the divorce in 2018 and including alimony can be a great tax planning opportunity,” Wittich pointed out, “and the savings can be split between the parties so both come out ahead.”