Contemplating Divorce? The Clock’s Ticking for the End of Alimony Tax Deduction
If the thought of spending one more holiday season with the in-laws isn’t enough motivation to finalize the paperwork, there’s one significant reason to consider moving things forward quickly: money.
The 2018 federal tax bill, the “Tax Cuts and Jobs Act,” contained a variety of financial changes. But for those contemplating or involved in a pending divorce, two of the most significant are: (1) the change eliminating the taxability/deductibility of alimony payments; and (2) the removal of the ability for a recipient spouse to save those alimony monies in an individual retirement account.
The Elimination of Taxability/Deductibility of Alimony
For divorces finalized before December 31, 2018 under the current law, alimony payments are deductible by the payor and counted as income (and taxable) to the recipient payee. In other words, the person paying alimony can decrease his or her adjusted gross income by those monies actually paid and the person receiving alimony must pay taxes (at his or her rate) on the monies received. This can have a real impact on both parties, especially if a payor is willing to pay more money to get into a lower tax bracket (or the payee can negotiate for slightly more if it would have an impact on the payor’s tax rate).
After the new year, however, alimony will no longer be deductible or taxable. In other words, if this taxability/deductibility affects your case, finalize the divorce by year-end or you’ll lose the tax deduction benefit of paying alimony forever.
Some confusion has arisen around what is meant by “finalized.” Does the divorce decree have to be actually signed by a judge and entered or just an agreement signed?
The new law states it applies to “any divorce or separation instrument … executed after December 31, 2018.” This language suggests that so long as an agreement is signed before the clock strikes midnight on December 31, 2018, a party would fall under the old rules. But, the conclusion isn’t black and white. Many lawyers would advise that the safer route would be to have the Final Order signed by a judge to be safe.
Impact on Retirement, Especially for Women
The taxability/deductibility of alimony isn’t the only change in the new tax bill. The previous law allowed a recipient divorced spouse to contribute to an individual retirement account (IRA) or Roth IRA based on the theory that the alimony received was “income” on which the recipient spouse paid taxes. With the elimination of the requirement that such alimony be taxed, also eliminated is the ability to contribute to such retirement accounts.
Many financial advisors have noted a negative impact of the change, especially on non-working spouses, often women. One study concludes that women are “80 percent more likely than men to be impoverished at 65” (National Institute on Retirement Security). Many factors, including the gender pay gap, living longer and longer times out of the workforce, mean retirement planning is already harder for women.
“The impact on this change is one less option for an alimony recipient to save for retirement in a tax-advantaged manner,” says Russ Thornton, a financial advisor with Wealthcare for Women. “This change could prove to be a real negative for divorced spouses who haven’t been working and don’t have access to a 401(k) or other company retirement plan.”
“While IRA contributions are a nice way to build tax-advantaged retirement savings, the impact on the recipient likely pales in comparison to the potential impact of the loss of tax deductibility by the alimony payor in most situations,” reports Lance Stafford, CFA, CDFA, an Advisor at SignatureFD. “If the realized net alimony payment declines substantially, the recipient’s ability to build savings of any kind will likely be reduced proportionately. This is why it’s so important to speak with a financial advisor sooner rather than later because there are some planning solutions that may present a work around of the dilemma created by lower after-tax income available for alimony payments.”
Why the Changes?
This change is promoted as a revenue generator for the government. According to the Joint Committee on Taxation, Congress estimates that the elimination of the “divorce subsidy” will increase federal funds by nearly $7 billion over ten years. That’s billion with a “b.”
But this pending change can have very real effects on the amounts of monies paid and received on an individual level. According to the IRS, in tax year 2016 more than 585,000 taxpayers claimed deductions for nearly $12.7 billion in alimony.
Many anticipate the new law could also make divorce proceedings more complicated and, in some cases, more acrimonious. One goal of the family lawyer is to maximize the amount of assets on the table. This new tax law takes one negotiation strategy off the table and makes it more challenging to offset equitable division with tax incentives to maximize what is on the table.
As a result, family lawyers have found themselves working overtime this holiday season trying to finalize divorces before the end of the year.
If the likelihood of entry of the actual final decree in a pending case is low, couples in the midst of a divorce — or even couples contemplating a prenuptial or postnuptial agreement — are advised to talk to a family law attorney and their personal accountant immediately if this tax change may affect their planning and decision-making.
Note: Although they can comment on the law, family lawyers generally do not offer tax advice. We recommend that tax professionals be consulted in making any future planning decisions.
Jessica Reece Fagan is a partner with Hedgepeth Heredia LLC. You can reach her at JFagan@hhfamilylaw.com