How the new tax changes will impact planning for divorcing couples
It is difficult to assess the impact of tax law changes will have on folks who divorce in the near future. Clearly, the spectrum of tax law changes for individuals ranges from tax brackets, deductions, and tax credits to tax shelters.
It is unclear if these new rules will make divorce more or less difficult to negotiate. Why? Many of the tax law changes take place effective 1/1/2018. However, the alimony rule for those divorced changes only after 12/31/2018. This means there is a one year span during which many individuals will experience considerable differences in their tax situation and lifestyle long before the impact of the new alimony rule becomes effective. Those who divorce before 12/31/2018 will be grandfathered under the existing IRS rules for alimony. Those who divorce when the new rule is effective must chart new territory in their financial negotiations.
Historical background of Alimony (For wives by the way):
The historical preference for awarding alimony and favoring the wife was due to the fact that women had no property rights during the marriage, even to their own inheritances. In addition, women had very limited access to outside employment and could not keep their own income. A divorced wife was a matter of social economy and the marital tie was an obligation and duty by the husband to maintain his wife. Yet, where the wife was at fault (for the marriage breakdown), she was not entitled to alimony.
Changes in societal habits, the introduction of equitable property division in divorce actions, and the ability and capacity of women to earn income, have helped to reduce the need for alimony in many cases. Many efforts also push toward the diminishing expectations for spousal support. Alimony is now an entitlement and determined by legal statute that sets forth various factors. Courts often may use the value of marital property for determining an alimony award.
Current Taxation of Alimony:
Currently, alimony is a way of shifting tax responsibility where taxable income is taken from one spouse and given to the other. There is an opportunity to create “free money” between the parties when one is in a higher tax bracket than the other because the IRS ends up subsidizing part of the alimony payment.
How? Here’s how the math works. The alimony payor can deduct dollar for dollar the alimony paid and the spouse receiving it must pay taxes on it. Imagine high-earning Spouse A now pays and deducts $35,000 a year in alimony. Spouse A’s income is federally taxed at 33 percent, so the deduction saves him $11,550.
Lower-earning Spouse B owes taxes on the alimony at a 15-percent rate, paying $5,250 instead of the $11,550 that would be due at Spouse A’s rate. The two have saved $6,300 between them, and Spouse A got a break that makes the payments more affordable. Spouse B gets more cash flow because of the tax savings to Spouse A. Without any tax break for the payor, Spouse A may not want to pay as much.
There will no longer be the opportunity for former spouses to trade dependency exemptions to achieve equitable tax relief when personal exemptions are eliminated under the new rules.
At first it seems that the lower income spouse gets tax relief from excluding alimony payments from taxable income. Interestingly 74 years ago, alimony was not taxable. It was treated like child support, which was tax neutral to payor and payee. It became taxable in 1942.
The current plan seems to penalize less wealthy couples where alimony payments come from future paychecks – not from the transfer of income generating assets that exist for wealthier individuals. When combined with child support, the availability of sharing after tax income is much narrower.
In Conjunction with Child Support
If the court focuses on the “best interests” of the child as the primary standard, child support will be the “defining payment”, and as such, quantified by state guidelines and formulas as well as by the child’s needs and age, not by the spouse’s. Conflicts over money are common after divorce, especially when it comes to child support. There will no longer be the opportunity for former spouses to trade dependency exemptions to achieve equitable tax relief when personal exemptions are eliminated under the new rules. Personal exemptions are being replaced with higher standard deductions. The idea of now having undifferentiated family support be tax neutral (aka alimony and child support) may fuel some of the most contentious issues of divorce around child custody.
Alternate Payment Options
Additionally, alimony has been paid in the form of mortgage payments, home equity line of credit payments, and property taxes often to assist the lower income spouse and allowing them to stay in the marital home. The payor spouse benefits from direct payment of these expenses and takes them as tax deductions because he/she can better utilize it, (as long as they remain on the title of the house).
Now the payor spouse faces competing options if they own their own home and are limited with respect to reduced tax deductions. The new limits for mortgage interest deduction, the zeroing out of home equity line interest, and the cap on property taxes further constrains incentives for spouses pay these expenses as a form of alimony for the purpose of keeping a spouse in the former marital home.
There is the opportunity to identify strategies for effecting more equitable transfer of wealth if alimony is less attractive or less feasible. As a divorce financial planner, examining legal, tax and financial options to achieve comparable results becomes an essential part to every divorce.
The threat to the financial security for lower income spouses is heightened and unknown at this time. The many forms of alimony depending on which sets you reside in may be eliminated simply out of practicality due to eliminated capacity to pay. There is a call to arms to explore carefully tax language for alimony and its contingencies as well. ◊
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