Tax Reform and Alimony
What Is Alimony?
Tax Reform is going to affect Alimony. Alimony refers to payments from one former spouse to the other required by a divorce or other court-ordered separation instrument. For alimony to apply, one spouse must have an actual need for alimony and the other spouse must have the ability to pay. Courts then consider several factors, including the marriage length, standard of living, and both spouses’ income. Generally, alimony is provided by the higher earning spouse to the lower earning spouse.
Before Tax Reform
1. Payor. The former spouse paying alimony (“Payor”) has been able to deduct alimony payments on his or her federal income tax return. For instance, a former spouse under a federal tax rate of 10% and paying $50,000 in alimony per year would save $5,000 each year in federal income taxes.
2. Payee. The former spouse receiving alimony (“Payee”) must list the alimony received as taxable income on his or her federal income tax return.
3. Recapture Rule. If alimony by the Payor either significantly decreases or ends within the first three years of payments, the Payor must pay for the amount previously deducted, “recapturing”that amount as taxable income. When this occurs, the Payee can deduct the same amount from taxable income, no longer paying taxes on the amount “recaptured.”
After Tax Reform
1. Payor. The Payor cannot deduct alimony from his or her federal income tax return.
2. Payee. Alimony received by the Payee is no longer taxable.
3. Recapture Rule. For divorces finalized after January 1, 2019, the recapture rule no longer applies since the Payor cannot deduct any alimony payments. For modifications of divorces or other separation instruments before January 1, 2019, the recapture rule still applies.
Have These Changes Occurred?
Alimony changes begin on January 1, 2019 and will apply to all divorces finalized on or after that date. The new alimony rules can also apply to changes to divorce or other court-ordered separation instruments before January 1, 2019, but only if the formers spouses expressly state in the change that they are applying the tax reform’s new alimony rules.
Significance of Changes
1. Payor. Likely Payors (usually spouses with higher incomes) may have a financial incentive to finalize a divorce prior to January 1, 2019 in order to receive the yearly savings of alimony tax deductions. These deductions can provide significant savings as alimony payments can continue for the life of the spouses.
2. Payee. For likely Payees (usually spouses with lower incomes), waiting to divorce until January 1, 2019 or after will free those spouses from paying taxes on alimony received. However, the Payor may also have less money to provide to the Payee due to now paying taxes on alimony payments. Additionally, Payees will no longer be able to use alimony received to contribute to IRA accounts as IRA accounts require contributions from taxable income.
3. Divorce Negotiations. Tax reform’s alimony changes may remove an incentive for reaching settlements prior to trial. Deducting alimony payments on federal income tax returns often encourages the higher earning spouse to agree to pay more in alimony, leading the parties to settle more quickly and more often.
For more information contact Max Factor.