New Year, New Tax Law for Divorcing Individuals
As we get settled into 2019, we’re faced with fresh changes to the tax code, brought about by the Tax Cuts and Jobs Act (TCJA) of 2017. One of the biggest changes that became effective as of January 1 is how alimony is treated in divorces finalized in 2019 and beyond.
Before January 1, 2019, alimony payments were tax deductible to the payor and taxable to the payee and had been handled that way for over 70 years (divorces finalized before 2019 retain that structure). For divorces finalized January 1, 2019 and on, alimony payments are no longer deductible to the payor and are not taxable to the payee. At first, one might think this is good news, at least for the payee. However, this change likely results in the payee receiving less spousal support. Research has shown that women are typically the recipients of spousal support and their income falls by more than 20% post-divorce, according to professor Stephen Jenkins of the London School of Economics. Lower alimony payments only make this statistic more staggering. Additionally, the payee who does not have earnings now, has no income and is no longer qualified to make contributions to retirement accounts. For the payor, it is a little more obvious why it is a disadvantage. As a quick example, take a single person making $240,000 and paying alimony of $90,000. With alimony being deductible, they fall in the 24% tax bracket. Without the deductibility of alimony payments, the payor jumps into the 35% tax bracket.
So, the question now becomes: what strategies can be used to counteract the negative outcomes of this change?
Reconsider the asset split
When considering the division of assets in divorce, intuitively, it makes sense to think all assets should be split 50/50. However, it may make sense for the non-income earning spouse to take more in the way of retirement assets (IRAs, 401(k)) in exchange for lower alimony payments. This is effectively one spouse “making payments” through a retirement asset, which means they are giving their ex-spouse money that they otherwise would have had to pay tax on if they had withdrawn it themselves. The receiving individual now has more assets to draw from to generate income (which would be taxable to them upon withdrawal). It is important to note that this strategy only works for a recipient who is at least age 59 ½, otherwise there is a 10% penalty for withdrawing from retirement assets. Additionally, note that a transfer from a retirement account would be a one-time transaction and needs to be formally laid out in the divorce agreement.
Use a Charitable Remainder Trust
Utilizing a Charitable Remainder Trust (CRT) could be a beneficial strategy from two perspectives. At the highest level, the income generating spouse (settlor) could create the trust during the divorce process and name the soon to be ex-spouse as beneficiary. This gives the settlor-spouse access to a tax deduction for the assets contributed and the beneficiary-spouse receives the annual income generated by the trust. The second level of benefit would be to contribute assets with low basis to the trust. Once appreciated assets are in the CRT, they can be sold and diversified without tax consequence, which alleviates the problem of trying to figure out which spouse gets stuck with low basis assets.
The changes to how alimony is handled is just one example of why the divorce process is ever-evolving and complex. As we always stress here at BDF, it is important to have an empowering team on your side to ensure you have great support through decisions like those laid out above. Contact our Divorce Practice Group on the specifics of your situation or check out our latest tips on Forbes here.
Kristina Caragiulo, CFP® is an Advisor who joined the BDF team in July of 2015. As an Advisor, some of Kristina’s responsibilities include providing analysis to clients in the different areas of financial planning, maintaining client relationships, and trading and rebalancing client investment accounts. Kristina received a Bachelor of Science degree in Agriculture and Consumer Economics with a concentration in Financial Planning from the University of Illinois at Urbana-Champaign. She is a CERTIFIED FINANCIAL PLANNER™ professional.