There is never a good time to get divorced, or even just think about getting divorced. Attorneys typically counsel clients to take time to think before ending their marriage. But time is running short for some couples. Impending changes to the tax code as a result of the Tax Cuts and Jobs Act (TCJA) will have a major impact on alimony payments. So, if alimony will be a part of your divorce settlement, you need to act quickly to take advantage of pre-TCJA alimony tax treatment.
Pre-TCJA Alimony Tax Treatment: How Alimony has Worked Since the 1940s
Alimony is the payment of support from a spouse who can afford to pay it to a spouse who needs it. Since the 1940s, the payer has been permitted to deduct alimony payments from gross income, even if he or she did not itemize expenses. The recipient then reported the support as his or her own taxable income. The payer’s marginal tax rate was nearly always higher than the recipient’s rate, so the payer’s reduction in taxes as a result of the alimony deduction exceeded recipient’s alimony tax payments. The government collected a bit less tax.
The alimony deduction rule has allowed an effective tax break for divorced families. The rule has been fair because the entire concept of graduated tax rates is that households who earn more can afford to pay a higher tax rate. The alimony deduction rule ultimately taxed alimony income at the rate of the recipient’s household, which would actually spend the income, rather than at the rate of the payer’s household, which would simply pay it over to the recipient. The net effect of this structure has been that payers could pay a little more alimony due to the tax deduction, and recipients could keep a little more after taxes, because of their typically lower tax bracket.
Each individual state sets its own alimony laws. In setting alimony amounts a state deemed fair, each state recognized that alimony payers were able to deduct their payments from income at tax time. The deduction allowed the payer to recover in tax savings a significant percentage of the amount paid. It was a “win-win” for both alimony payers and recipients. It all worked well for about seventy-five years.
How the TCJA of 2017 Changes the Alimony Tax Law
In the fall of 2017, Congress passed what has been touted as the largest tax cut in history: the Tax Cuts and Jobs Act of 2017, TCJA for short. The massive tax cuts created a huge budget deficit, so Congress looked for places to fill at least some the budget holes. Elimination of the alimony deduction appeared to provide a small part of the budget deficit solution. As a result, after December 31, 2018, payers will no longer be permitted to deduct alimony payments. And alimony will no longer be taxable to recipients.
Why You Need to Act Now
TCJA changes alimony tax treatment only for alimony orders pursuant to an instrument of divorce entered after December 31, 2018. Couples planning to divorce may want to hasten their proceedings — or at least their drafting and signing of divorce instruments to take advantage of pre-TCJA alimony tax treatment. An instrument of divorce must specify periodic payments and the parties must reside in separate households. Experts believe an instrument signed before December 31, 2018, will qualify for pre-TCJA tax treatment, even if the divorce is not yet final. If the parties sign their divorce instrument before the end of this year, they can also agree to pre-TCJA tax treatment for any subsequent modification of their alimony arrangement. In that way, couples who sign an alimony instrument of divorce before December 31, 2018, can preserve the deductibility of alimony far into the future.
Why Alimony Orders Will Likely Go Down
If states maintain the same alimony amounts for post-2018 alimony orders as they awarded for prior orders, newly divorced recipients will get to keep a lot more, 100% of what they receive, tax-free from federal income tax. And payers will have to bear the full out-of-pocket payment cost of the new orders. But there is no reason to think that new orders will, in fact, be the same as old ones. And it would not be fair for a new payer to pay the same amount in after-tax dollars as a payer in the same circumstance paid in tax-deductible dollars before January 1, 2019. Newly divorcing couples should assume that TCJA will cause states to change their alimony laws, so that alimony orders go down after January 1.
How Can You Adjust for the TCJA Changes?
One way to adjust for the TCJA alimony tax treatment is to equally divide the actual added cost in income taxes between the two former spouses. An accountant can calculate how much the payer would have saved each year under the pre-TCJA alimony tax rule. The accountant can then calculate how much extra tax the recipient would have paid under the pre-TCJA rule. Averaging the two numbers and decreasing the alimony amount by the resulting number will equalize the actual tax cost of the lost alimony deduction.
Fern Frolin is of counsel to the Mirick, O’Connell Boston office. She is a fellow of the American Academy of Matrimonial Lawyers and has been continuously listed in Best Lawyers in America since 2006. www.mirickoconnell.com
Susan Miller (CPA, CFP, CDFA) is president of Aurora Financial Advisors, LLC, a wealth management firm in Wellesley, MA. She works extensively with family lawyers and provides financial advice to divorcing couples and individuals. www.AuroraFA.com