Alimony & Tax Law
Also known as spousal support or maintenance, alimony consists of payments made by one ex-spouse to the other ex-spouse after a divorce or separation. State laws determine whether and how much alimony will be awarded, as well as the circumstances in which it can be terminated. If you are paying or receiving alimony, you should understand its tax implications. These have changed following the enactment of the Tax Cuts and Jobs Act in 2018. You should be aware that this discussion covers only alimony. Any other payments related to a divorce, such as child support, are not covered by the rules described below.
Historically, an ex-spouse who paid alimony was able to deduct that cost as a non-itemized deduction on their return. An ex-spouse who received alimony was required to report it as taxable income. As the nature of alimony suggests, the payor spouse is typically much wealthier than the payee spouse. This arrangement thus resulted in a net benefit for the ex-spouses and a net loss for the government. It facilitated divorce settlements by encouraging ex-spouses to set up generous alimony payments.
Impact of the Tax Cuts and Jobs Act
When the Tax Cuts and Jobs Act went into effect, it removed the alimony deduction as well as the responsibility of the payee spouse to pay taxes on alimony. Therefore, the payor spouse may be significantly worse off under the new system, while the payee spouse may be significantly better off. The federal government is also much better off under the new system, which is expected to increase tax revenue by billions of dollars during the existence of the Tax Cuts and Jobs Act. This tax structure incentivizes payor spouses to demand smaller alimony payments in divorce settlements. It may even reduce the probability of settling a divorce in which alimony is an issue.
However, you should be aware that the Tax Cuts and Jobs Act only applies to divorces that were finalized in 2019 or later. If you divorced your ex-spouse before 2019, you can continue following the original rules. Ex-spouses can agree to modify a divorce settlement agreement for a pre-2019 divorce so that the tax treatment of alimony follows the Tax Cuts and Jobs Act rules, but both ex-spouses must agree voluntarily to this modification. (It seems unlikely that this would happen, but the payee spouse might end up in a higher tax bracket than the payor spouse after some time has passed, which might make a modification logical.)
If the lower-earning spouse is at least 59½ years old, the spouses may want to avoid the impact of the Tax Cuts and Jobs Act by integrating retirement funds in the divorce settlement instead of arranging for traditional alimony payments. The higher-earning spouse might agree to transfer money from their retirement account to the lower-earning spouse’s retirement account. The lower-earning spouse would need to pay a one-time tax on the transfer, while the higher-earning spouse would not need to pay any tax. You can use this strategy even if the lower-earning spouse is younger than 59½ years old, but a 10 percent early withdrawal penalty would apply to the transfer, making it less attractive.
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