Tax Burden Shifts in Divorces
The Tax Cuts and Jobs Act (TCJA) featured an important provision for divorcing couples to consider. For divorces executed after Dec. 31, 2018, alimony will no longer qualify as a tax-deductible expense, while alimony payments will be tax-free to recipients. In other words, the tax burden on that income will shift from the receiver to the payor.1
However, any agreements completed before the end of the year will still be subject to previous deductibility allowances, and any divorce agreements already in existence will not be affected, unless they are modified to specifically state that the TCJA treatment of alimony payments now applies.2
It is important to stay abreast of changes in tax rules and guidelines because divorce agreements can impact retirement income strategies for both parties. It may be worth considering alternative alimony arrangements in the future. For example, giving an ex-spouse an IRA as prepaid alimony (as opposed to legal separation of assets).3
Since most divorces occur among couples ages 55 to 64 years old,4 this strategy enables the recipient to tap traditional IRA funds either immediately or soon following the divorce, with withdrawals taxed at a potentially lower income bracket. However, if the ex-spouse withdraws money from the IRA before age 59 ½, they will generally have to pay a 10 percent early withdrawal penalty in addition to income tax on the amount withdrawn. A Roth IRA’s contributions have already been taxed, so qualified withdrawals will be tax-free. If you’d like help considering different alimony strategies based on your current financial situation, please let us know.
While a lump-sum alimony payment can help eliminate confrontations about late or partial payments, it does present a potential problem under the new tax law. In some situations, the recipient may be willing to accept a tax-deferred account and its accompanying tax burden for a couple reasons.
First, the account may offer the potential for a larger payout through tax-deferred growth throughout a substantial timeframe. Second, it may offer the receiver the chance to remarry without having to factor in the financial impact of losing alimony payments.5 However, an ex-spouse under age 59½ may need cash alimony to help pay living expenses, and withdrawals of retirement funds could be subject to a 10 percent penalty.6
The new tax law also presents an interesting quandary: The transfer of alimony tax liability may motivate the payor to complete divorce proceedings before the end of the year while the recipient may be inclined to delay until 2019. This can further complicate a contentious divorce and is a good reminder why working with an experienced attorney and financial advisor throughout the process is so important.7
Additionally, a frequently overlooked aspect of financial planning in divorce is estate considerations. Once your divorce is settled, it’s important to review all your financial documents to update beneficiaries on investment and bank accounts, as well as insurance policies. Don’t forget to also update your will, health care proxy and power of attorney, if necessary.8