The Tax Cut & Jobs Act that was recently passed has already caused taxpayers to accelerate certain financial decisions as we transition from the current tax laws to the new tax laws over the course of the next two years. Taxpayers are running to their town office to prepay property tax prior to December 31, 2017 to capture the deduction before it’s capped in 2018. Companies are looking at how they are incorporated to take advantage of the new 20% deduction available in 2018. On deck for next year, married couples contemplating a divorce will have an incentive to sign their divorce agreement prior to December 31, 2018. Wait……what? Let me explain.
Current Tax Law: Alimony Is Tax Deductible
Under the current tax law, alimony payments are taxable income to the ex-spouse receiving the payments and they are tax deductible to the ex-spouse making the payments. When alimony is awarded pursuant to a divorce, it’s typically because there was a disparity in the level of income between the two spouses during the marriage. The ex-spouse paying the alimony, in most cases, is the higher income earning spouse both before and after the divorce finalized.
Let’s look at this in a real life example. Jim and Sarah have decided to get a divorce. Jim makes $300,000 per year and Sarah is a homemaker with $0 income. Pursuant to the divorce agreement, Jim will be required to pay Sarah $50,000 per year for 5 years. Jim will be able to deduct the $50,000 each year against his taxable income and Sarah will claim the $50,000 as taxable income on her tax return. Based on the 2018 Individual Tax Brackets, the top end of Jim’s income is in the 35% tax bracket. Thus, paying $50,000 in alimony really results in an “after-tax” expense to Jim of $32,500.
$50,000 x 35% = $17,500 (fed tax savings)
$50,000 – $17,500 = $32,500 (after tax expense to Jim)
Sarah will claim that $50,000 in alimony payments as income and let’s assume that the alimony payments are her only income for the year. Next year, as a single filer, Sarah will receive a standard deduction of $12,000, and the remainder of the $38,000 will be taxed at a blend of her 10% & 12% tax rate. As a result, Sarah will only pay about $4,400 in taxes on the $50,000 in alimony income.
To sum it all up, if the $50,000 is taxed to Sarah, approximately $4,400 will be paid to the IRS in taxes and she nets $45,600 in after tax income. However, if Jim was not able to deduct the alimony payments and had to pay tax on that $50,000, he would first have to pay the $17,500 in taxes to the IRS, and then he would hand Sarah a check for $32,500 after tax. Sarah is worse off because she received less after tax income. Jim would ultimately be worse off because he would need to part with more pre-tax income to create the same after tax benefit for Sarah. The IRS is the only one that wins.
Gaming The System
Since divorce agreements, in most states, are not required to adhere to predefined calculations for splitting assets, alimony payments, and in some cases child support, the tax game can be played when there is a high income earning spouse and alimony payments in the mix. In exchange for fewer assets or less child support, some divorce agreements have purposefully shifted more to alimony. The ex-spouse with the big income gets a bigger tax deduction and the ex-spouse receiving the alimony payment is able to take full advantage of their lower tax brackets and maximize their after tax income.
Alimony Is No Longer Deductible
To stop the tax game, included in the new tax bill was a provision that specifically states that alimony payments will no longer be deductible by the payor, nor reportable as income by the recipient, for divorce agreements signed after December 31, 2018.
The good news is this will not impact the ability to deduct alimony payments for divorce agreements that are currently in place. The bad news is for divorce agreements signed after December 31, 2018, the high income earner will no longer be able to deduct the alimony payments. That eliminates the tax arbitrage that has been used in the past to make the pie larger for both spouses. In general, if you shrink the size of the asset and income pie, it leaves more to fight about because each spouse is trying to preserve their standard of living as much as possible post-divorce.
For couples that have been sitting on the fence about getting divorced, this could be the catalyst to start the process in 2018 to make sure they have a signed agreement prior to December 31, 2018.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.