The vanishing alimony tax deduction and divorce planning

By Amy Fontinelle
Amy Fontinelle is a personal finance writer focusing on budgeting, credit cards, mortgages, real estate, investing, and other topics.
Posted on Nov 19, 2018

Alimony, sometimes called spousal maintenance or spousal support, is a factor in many divorces. According to IRS data, taxpayers claimed over $10.4 billion in alimony received and more than $12.6 billion in alimony paid in 2016.1

For decades, alimony has been tax deductible to the payer and taxable to the recipient. As part of the Tax Cuts and Jobs Act of 2017, however, those rules are changing.

In short, here’s what you should know about the law:

  • The old rules will not apply to divorce or separation agreements finalized on or after January 1, 2019.
  • The old rules will still apply to divorce or separation agreements finalized on or before December 31, 2018.
  • If you divorce on or after January 1, 2019, you will need to do careful financial planning to try and achieve the best result.
  • This planning may include retirement accounts and life insurance.

The what and why of alimony

Simply put, alimony is a series of payments, usually made monthly, to a spouse for continued monetary support after the break-up of a marriage.

Alimony is influenced by each spouse’s contributions to the marriage, their financial situations, and their physical and mental health. Payments are supposed to ensure that both individuals will at least be able to meet their basic needs after the divorce, and at best maintain the standard of living they enjoyed during the marriage.

A couple may agree to alimony as part of their divorce settlement, or if the couple can’t agree and they take their divorce to court, a judge may order it. Who gets alimony after a divorce, how much they get, and for how long are subject to state law. Alimony can be one time, for the short or long term, or can even be indefinite.

If a divorcing couple has been married for many years and one spouse earns significantly more than the other, a court may decide alimony may be warranted.

For example, in a family where one spouse was the sole income earner and the other has been out of the workforce for 10 years raising their children, alimony might make sense, at least until the stay-at-home spouse can refresh their skills and secure a full-time job.

Tax treatment of alimony for pre-2019 divorces

If you pay alimony under a divorce or separation agreement entered into through the end of 2018, you can deduct it from your taxes. This deduction is available even to taxpayers who don’t itemize their deductions. If you receive alimony, you have to pay tax on it, just as you do with other forms of income.

Because alimony is either deducted from income (in the payer’s case) or added to income (in the recipient’s case), the amount of tax saved or paid depends on the taxpayer’s marginal tax rate, or tax bracket.

Furthermore, for pre-2019 divorce or separation agreements, alimony is allowed as an “above-the-line” deduction, meaning it reduces adjusted gross income (AGI). Because AGI is used for other tax purposes, an above-the-line deduction can be even more valuable than other kinds of deductions.

It also depends on where taxable income falls within the bracket. The individual’s top marginal rate may only apply to a portion of alimony paid or received.

But let’s consider a simplified example where the alimony payer’s and recipient’s taxable incomes both fall squarely within the brackets so that all alimony is taxed at the same marginal rate.

For 2018, suppose “Caroline” receives $10,000 in alimony for the year from her ex-husband, “Mike.” Caroline, an individual taxpayer with $50,000 of taxable income, is in the 22 percent tax bracket. When she receives $10,000 a year in alimony from Mike, she has to pay $2,200 in taxes on it. In effect, she only receives $7,800.

Mike is in the 32 percent tax bracket as an individual taxpayer with taxable income of $180,000. By paying Caroline $10,000 in alimony, Mike’s tax bill decreases by $3,200. In effect, it only costs him $6,800 to pay alimony.

This is why some lawmakers called the pre-2019 alimony system a subsidy to alimony payers, and it’s one of the justifications cited for changing the law.

How alimony taxation changes in 2019

Under the Tax Cuts and Jobs Act, alimony payments required by divorce or separation agreements executed on or after Jan. 1, 2019, will not be tax deductible to the payer or taxable to the recipient. And while many provisions of the Tax Cuts and Jobs Act expire after 2025, such as the tax rate changes, the change in alimony taxation is permanent .

Congressional backers of the law change expect it to provide billions of dollars in additional revenue for the government. It may also reduce problems with the presumed underreporting of alimony received and overreporting of alimony paid (cited in a 2014 report from the Treasury Inspector General for Tax Administration).

Certified Divorce Financial Analyst® Rosemary Frank of Brentwood, Tennessee, suggested in an interview that the new law “is effectively a tax increase on families and damaging to both spouses.” Instead of the recipient, who is presumably in a lower tax bracket, paying taxes on alimony, the payer, who is typically in a higher tax bracket, will pay those taxes, leaving less money for the parties to divide between them.

Not only that, she observed, but the higher-income spouse, who loses the alimony deduction, may wind up in a higher tax bracket, leaving even less money.

Frank also expressed concerns that overcorrections will be made in future alimony calculations in efforts to compensate for the tax difference.

“Overcorrections result when people forget that income taxation is at marginal rates,” she explained. “If someone is in the 32 percent bracket, they apply that rate to the entire alimony award under consideration. However, it may be that only the last $2,000 fell into this rate, and most of it is taxed at only 24 percent, which represents the vast majority of the cost, to the payer, associated with the loss of deduction.”

Another possibility Frank described is that alimony may be calculated by looking at the tax bracket applicable to the payer’s gross income instead of net taxable income.

A new role for retirement accounts in alimony cases

The new system will simplify tax reporting for the people it applies to. However, it may complicate divorce decrees. Divorcing couples, their attorneys, and their financial advisors may find themselves seeking new ways to minimize taxes to soften the financial blow of both the changed law and the divorce itself.

“Certified divorce financial analysts are exploring ways to use retirement accounts as vehicles to pay alimony using pre-tax dollars,” said Laurie Itkin, a Certified Divorce Financial Analyst® professional in San Diego. “This will create some complexity that never existed, but will enable the recipient to be paid more while not making a huge dent in the payer's disposable income.”

For instance, when an alimony payer uses retirement funds to pay alimony, he or she is generally using pretax funds. Federal and state income taxes will eventually have to be paid on these funds when the account holder reaches age 70 1/2 because of required minimum distribution rules. The alimony recipient, who is usually in a lower tax bracket than the alimony payer, will be the one who pays those taxes.

As long as the recipient is at least 59 1/2 when the funds are withdrawn, the 10 percent early withdrawal penalty does not apply. But this strategy may not work well for younger people, Itkin pointed out.

Another option is to use a qualified domestic relations order (QDRO) which, when drafted properly, allows funds to be withdrawn from an ex-spouse’s 401(k) without penalty, though income tax is still due.

“Taking money of out retirement plans for purposes other than retirement is not an attractive option,” Itkin acknowledged in an interview. “But neither is paying alimony using after-tax money.” (Learn more: Severing the knot after age 50 .)

The changing nature of financial planning for divorce will also point to the use of life insurance as an important guardrail for alimony, experts suggested.

Morris Armstrong , an enrolled agent in Cheshire, Connecticut, provided a simplified example of how this arrangement can work:

Alimony owed: $2,000 per month for 7 years; $2,000 x 12 x 7 = $168,000

Child support owed: $1,000 per month for 8 years; $1,000 x 12 x 8 = $96,000

Total obligation: $264,000

Factoring in discounted cash flows and the tax-free nature of policy proceeds, a life insurance policy on the party responsible for paying alimony with a 10-year term and a face value of $250,000 would be appropriate to protect the party receiving alimony. ( Learn more: Divorce and life insurance: Considerations .)

Conclusion

The 2017 Tax Cuts and Jobs Act does not affect alimony agreements executed on or before December 31, 2018, but it does affect those executed on or after January 1, 2019. Starting then, alimony payments will no longer provide a tax deduction for the spouse making the payment or be taxable to the spouse receiving the payment.

Ex-spouses operating under a pre-2019 alimony agreement can also agree to modify their agreement so that the TCJA treatment applies, which must be stated in writing in the new agreement.

Because the new law can have a significant effect on finances, it may be wise to speak with your attorney and a financial advisor to help navigate any alimony decisions.

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Internal Revenue Service, “Individual Income Tax Returns: Line Item Estimates,” 2016.

The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own, and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.