As 2019 begins, the big news in divorce is implementation of the Tax Cuts and Jobs Act of 2017 (“Trump Tax”) and its key provision that changes the way alimony has been taxed for decades.
Under old federal tax laws, which continue to govern agreements made before the end of 2018, alimony payments were 100 percent tax deductible by the payor and 100 percent taxable to the recipient. The new rules reverse this. For alimony agreements put in place after January 1 of this year, the tax burden for alimony falls squarely on the shoulders of the paying spouse who must now claim this money as part of taxable income.
At face value, the new rules would appear to be a boon to recipient spouses who will now receive alimony tax free. However, what has become clear is that this altered tax structure is poised to take hidden and not-so-hidden financial tolls on both parties.
The tax change on alimony was not an act of altruism. The Joint Committee on Taxation has estimated this single provision will increase revenue to the IRS by approximately $6.9 billion over 10 years. As tax liability shifts back to the higher earner and money is generally taxed at a higher rate, ultimately this will mean that less money is available for parties to divide between them, and share with their children.
The former “tax break” for paying spouses often served as a way to ease alimony negotiations in divorce. It was possible to obtain higher alimony amounts for recipient spouses when payor spouses could see the considerable tax perk they would receive, and both parties could walk away feeling satisfied. In today’s new tax landscape, it’s a given that typical payor strategy will be how to minimize alimony at all costs. The recipient won’t be paying tax on alimony received, but it can be predicted that there be less of it anyway.
Let’s take a closer look at what this new tax treatment might look like in practice and the larger context of where we go from here.
Tax Effects of the New Law — A Closer Look
Divorcing couple Carl and Jill are an example of how the new alimony tax structure could play out. Carl earns $300,000 per year while Jill earns $80,000. In their divorce agreement, Carl agrees to pay Jill alimony of $70,000 per year for a certain number of years. They have two children, who live primarily with Jill, giving her head of household tax filing status. After the divorce, Carl will file as single. For the sake of simplicity, we will also assume that each party will take the standard deduction on their taxes.
Had Carl and Jill reached an alimony settlement prior to 2019, Carl would be able to take what is known as an “above-the-line” deduction for his alimony payments of $70,000. This deduction plus the standard deduction would reduce his taxable income from $300,000 to $218,000, placing him in the 35 percent tax bracket. Carl would be required to pay $51,990 in federal tax ($45,690 plus 35 percent of the excess over $200,000). His net income after paying taxes and alimony would, therefore, be approximately $178,010.
If Carl and Jill reached their agreement in 2019 under the new rules, with the same income and the same alimony payments, Carl’s taxable income would be $287,800 ($300,000 minus $12,200 for the revised 2019 single filer deduction). He would remain in the 35 percent bracket, which in 2019 will require him to pay taxes of $75,924 ($46,629 plus 35 percent of the amount over $204,100), giving him an after-tax income on paper of $224,077. After paying the $70,000 in alimony, however, he will only keep $154,076.
Under a 2018 agreement, Jill would add alimony payments to her income, giving her $150,000, of which $132,000 is taxable when her head of household deduction is subtracted. This puts her in the 24 percent tax bracket, which requires her to pay taxes of $24,578 ($12,698 plus 24 percent of the excess over $82,500). Her net income is therefore $125,422.
Under a new agreement signed in 2019, Jill’s taxable income would be only $61,650 ($80,000 minus $18,350 for the revised 2019 single filer deduction). This drops her to the 22 percent bracket and requires her to pay taxes of $8,001 ($6,065 plus 22 percent of the amount over $52,850). Her after-tax income on paper is now $71,999. After receiving $70,000 in alimony, however, she will actually have $141,999.
There are clear advantages for Jill in this change of status, and clear detriments for Carl. But perhaps the most dramatic effect of the Trump Tax is the total combined after-tax income available to both parties. Under the 2018 analysis, Jill and Carl’s combined after-tax income is $303,433, while under the 2019 analysis, it will be only $296,076. The couple as a whole therefore loses $7,357 per year, or $613 per month. In the grander scheme of things, what this represents is an increased tax on alimony itself.
The Difference a Year Can Make
Given what the calculations tell us about Carl’s tax situation, it’s probable that Carl, and other high-income spouses like him, will have an obvious new negotiating position: Offer to pay less. If Carl subtracts the amount of his lost tax break ($23,934) from what he would have otherwise agreed to pay ($70,000), he may offer that lower amount ($46,066) in alimony negotiations so that he will end up in the same position as he would have been in under the old rules. If Jill accepts Carl’s offer to pay an amount that compensates him for his lost tax break, this deficit would fall entirely on her.
Are the New Tax Effects Fair?
The imposition of what is essentially an increased tax on alimony seems to be neither logical nor fair. Alimony operates to partially equalize income between former partners who would otherwise have very unequal incomes. It seems rational that the party who ends up with the income should be the party who pays the taxes on it. If that party is a lower earner and therefore the government receives a little less tax, that is consistent with the entire graduated structure of the federal tax code. Under the new rules, on the other hand, Carl must pay tax at a rate that assumes he has the benefit of income he does not actually get to keep.
The argument could be made that the overall effect of the 2019 change is to penalize divorced parties. This result seems especially unfair in light of the fact that divorced or single people generally need a tax break more than married people do, since it costs a lot more to maintain two households than it does to maintain one.
How Attorneys Can Help Mitigate Tax Effects
It has always been important to try to minimize the tax effects of divorce for clients as much as possible, whether they are paying or receiving alimony. The changes to the tax code make it more important than ever to have a good accountant available during settlement negotiations. There will certainly be some changes in strategy to consider. For example, sometimes parties would prefer to cut ties by making one lump sum payment at the time of divorce instead of smaller monthly payments for years. In the past this was generally not advisable for paying spouses, because the IRS would treat large lump sum payments as property transfers which were not tax deductible. This is now less of a concern, since a paying spouse can no longer deduct the tax on any alimony payments, regardless of whether they are lump sum or periodic.
Avoiding the negative tax effects entirely may not be possible, but a creative attorney will explore all possibilities. Couples should look carefully at the availability of any non-liquid assets which would be fully or partially taxable on withdrawal, such as retirement accounts, stocks, or brokerage funds which have increased in value. A higher earner may be able to transfer more of such assets to a lower earner in exchange for paying less alimony. If the transfer is properly executed, the recipient rather than the payer would bear the tax consequences down the road.
Any such transfers must be done only after careful consideration of all of the implications, which will vary depending on the nature of the assets in question. It is especially important to consult with a Qualified Domestic Relations Order (QDRO) attorney before executing transfers of retirement assets. There are often very specific requirements for such transfers and the consequences of failing to comply with these can be dire.
If a retirement asset is available, but the lower earner is under 59½ and needs cash right away, it may be possible to set up periodic payments from the transferred account without triggering an early withdrawal penalty. It is critical to consult with a tax professional about the correct way to do this. It is also important to keep in mind the downside of using a retirement asset in lieu of alimony: It may drain funds that will also be needed later in life. As with all aspects of financial settlement in divorce, this requires a careful cost benefit analysis.
Trump Tax — Here to Stay?
Many provisions of the Tax Cuts and Jobs Act that affect individuals are subject to sunset after 2025, with one notable exception: Alimony. As the law is written, alimony changes are not scheduled to expire. So where do we go from here? In the buildup to November’s midterm election, several prominent Congressional Democrats, including Bonnie Watson Coleman, D-N.J, called for repealing and replacing the Tax Cuts and Jobs Act for myriad reasons. As the House of Representatives changes party leadership, there appears to be gathering strength for revising a tax plan that clearly has limitations. If parties at odds with each other in divorce can successfully negotiate to reach a positive resolution, let’s hope the same thing can happen in Washington, D.C.
Bari Z. Weinberger is the owner and managing partner of Weinberger Divorce & Family Law Group in Parsippany.