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In early 2019, big news with the divorce is the implementation of the Tax Cuts and Jobs Act of 2017 (“Trump Tax”) and its key provision, which will change the way alimony has been taxed for decades.
According to the old federal tax laws, which regulate agreements concluded before the end of 2018, maintenance payments were 100 percent taxable for the payer and 100 percent for the recipient. The new rules reverse this. In the case of maintenance contracts concluded after January 1 of this year, the maintenance tax burden rests directly on the shoulders of the paying spouse, who now has to claim this money as part of the taxable income.
At first glance, the new rules appear to be a boon for the spouses who are now receiving tax-free maintenance. However, it has become clear that this changed tax structure is poised to take hidden, and not so hidden, financial tributes on both sides.
The change in the maintenance tax was not an act of altruism. The Joint Tax Committee estimates that this single provision will increase IRS revenues by approximately $ 6.9 billion over a 10 year period. As the tax liability shifts back to the higher earners and money is generally taxed more heavily, this ultimately means that the parties have less money to divide up and share with their children.
The former “tax break” for paying spouses was often used to facilitate maintenance negotiations in the event of divorce. It was possible to get higher amounts of maintenance for the receiving spouse when the paying spouses could see the substantial tax breaks they would receive and both parties could leave with satisfaction. In today’s new tax landscape, it goes without saying that the typical payer strategy is to minimize maintenance at all costs. The recipient will not pay tax on the alimony received, but it is foreseeable that it will be less anyway.
Let’s take a closer look at what this new tax treatment might look like in practice, and the wider context in which we go from here.
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Tax implications of the new law – a closer look
The divorced Carl and Jill is an example of what the new alimony tax structure could do. Carl makes $ 300,000 a year while Jill makes $ 80,000. In her divorce settlement, Carl agrees to pay Jill $ 70,000 per year in alimony for a specified number of years. They have two children who mostly live with Jill, which gives her tax return status as head of household. After the divorce, Carl will file for single. For the sake of simplicity, we also assume that each party takes the standard deduction from their taxes.
If Carl and Jill had made an alimony agreement before 2019, Carl could make an “over the line” deduction for his alimony payments of $ 70,000. That 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 have 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 new rules settlement in 2019 with the same income and alimony payments, Carl’s taxable income would be $ 287,800 ($ 300,000 minus $ 12,200 for the revised 2019 individual deduction). He would stay in the 35 percent tier, which will force him to pay $ 75,924 in taxes in 2019 ($ 46,629 plus 35 percent of the amount over $ 204,100), giving him a Generated after-tax income of $ 224,077 on paper. After paying $ 70,000 in alimony, however, he only keeps $ 154,076.
Under a 2018 agreement, Jill would add child support to her income, earning her $ 150,000, of which $ 132,000 is taxable when her head of household is deducted. This puts her in the 24 percent tax bracket that requires her to pay $ 24,578 in taxes ($ 12,698 plus 24 percent of the $ 82,500 excess). Your net income is therefore $ 125,422.
According to a new agreement signed in 2019, Jill’s taxable income would be only $ 61,650 ($ 80,000 minus $ 18,350 for the 2019 revised individual tax deduction). This drops her to the 22 percent mark and charges her $ 8,001 in taxes ($ 6,065 plus 22 percent of the amount above $ 52,850). Your after-tax income on paper is now $ 71,999. However, after receiving $ 70,000 in maintenance, she actually has $ 141,999.
This status change has clear advantages for Jill and clear disadvantages for Carl. But perhaps the most dramatic effect of the Trump tax is the total combined after-tax income available to both parties. According to the 2018 analysis, Jill and Carl’s combined after-tax income is $ 303,433, while according to the 2019 analysis it will be only $ 296,076. The couple as a whole are losing $ 7,357 a year, or $ 613 a month. By and large, this means an increased tax on the maintenance itself.
The difference a year can make
Given what the calculations tell us about Carl’s tax position, it is likely that Carl and other high-income spouses like him will take an obviously new bargaining position: Offer to pay less. If Carl subtracts the amount of his lost tax break ($ 23,934) from what he would otherwise have been willing to pay ($ 70,000), he can offer that lower amount ($ 46,066) in maintenance negotiations so that he ends up in the same situation as him would have been there according to the old rules. If Jill accepts Carl’s offer to pay an amount to compensate him for his lost tax breaks, that deficit would fall entirely on her.
Are the new tax effects fair?
The introduction of an essentially increased maintenance tax appears neither logical nor fair. Alimony serves to partially equalize income between former partners who would otherwise have very unequal incomes. It seems reasonable that the party receiving the income should be the party paying taxes on it. If that party is a low-wage earner, and therefore the state receives slightly less taxes, then this corresponds to the entire tiered structure of the federal tax code. On the other hand, under the new rules, Carl has to pay taxes, which assume that he has income that he cannot actually keep.
It could be argued that the overall effect of the 2019 change is to punish divorced parties. This result appears particularly unfair against the background that divorced or single people generally need more tax breaks than married people, as it is significantly more expensive to maintain two households than one.
How lawyers can help mitigate tax effects
It has always been important to try to minimize the tax implications of divorce for clients, whether they are paying or receiving alimony. The changes in the tax code make it more important than ever to have a good accountant at your side when negotiating a settlement. There will certainly be some changes in strategy to consider. For example, the parties sometimes prefer to end ties by making a one-time lump sum payment at the time of divorce rather than years of lesser monthly payments. In the past, this was generally not advisable for paying spouses as the IRS treated large lump sums as non-deductible capital transfers. This is now less of a concern as a paying spouse will no longer be able to deduct maintenance payments from tax, regardless of whether the payments are one-off or recurring.
Total avoidance of the negative tax effects may not be possible, but a creative lawyer will explore all options. Couples should carefully consider the availability of illiquid assets that would be taxable in whole or in part if paid out, such as: B. retirement accounts, stocks or broker funds that have increased in value. A high-income earner may be able to transfer more of these assets to a low-income earner if he pays less alimony. If the transfer is carried out properly, the recipient and not the payer would bear the tax consequences.
Such transfers may only be made after careful consideration of all implications, which vary depending on the nature of the assets involved. It is especially important to consult a qualified domestic relations attorney (QDRO) before making any retirement funds transfers. There are often very specific requirements for such transfers, and failure to comply with them can have serious consequences.
If you have retirement assets, but the low-wage earner is below 59½ and needs cash immediately, you may be able to set up periodic deposits from the transferred account without incurring an early withdrawal penalty. It is important to consult with a tax advisor about the correct course of action. It’s also important to keep an eye on the downside of using retirement savings instead of alimony: it can consume funds that will also be needed later in life. As with all aspects of the financial process of a divorce, this requires a careful cost-benefit analysis.
Trump Tax – To Stay Here?
Many provisions of the Tax Cuts and Jobs Act that affect individuals will be subject to expiration after 2025, with one notable exception: alimony. As the law is written, maintenance changes will not expire. So where do we go from here? In the run-up to the November mid-term election, several prominent Democrats in Congress, including Bonnie Watson Coleman, DN.J., called for the Tax Cuts and Jobs Act to be repealed and replaced for a myriad of reasons. With the House of Representatives changing party leadership, the strength seems to be growing to revise a tax plan that clearly has limits. If parties at odds over a divorce can negotiate successfully to reach a positive settlement, we hope the same can happen in Washington, DC
Bari Z. Weinberger is the owner and managing partner of the Weinberger Divorce & Family Law Group in Parsippany.