In 2017, Congress passed one of the largest tax cuts in history: the Tax Cuts and Jobs Act of 2017, TCJA for short. The tax cuts had the potential to increase the budget deficit. Therefore, Congress eliminated the deductibility of alimony to help address that potential increase. As a result, as of December 31, 2018, alimony payers will no longer be allowed to deduct alimony payments. And alimony will no longer be taxable to the recipients.
How does that affect you?
1. It can make negotiating a divorce settlement more difficult.
When the tax laws allowed the spouse paying alimony to deduct the payments, the spouse could use the payments to lower his or her gross income and possibly his or her tax bracket. This resulted in a benefit to the alimony paying spouse which made it possible for the payor to lessen, and even possibly set off the cost of the alimony by reducing the taxes he or she paid on their entire income. This was a powerful incentive for the alimony paying spouse. It effectively shifted what was previously “family” income to the spouse making less money, which resulted in less taxes being paid on the same total amount earned by both spouses. This was a net gain to the divorced couple and a net loss to the IRS, which is precisely why the law was changed.
2. More parties will be using retirement funds to satisfy alimony needs.
In Rhode Island, alimony is now rehabilitative. This means that it is temporary and is meant to be paid long enough to put the receiving party in a position where they can support themselves, although the law does allow for the award of alimony for long periods of time under certain circumstances.
“Alimony should be ‘payable for a short, but specific and terminable period of time, which will cease when the recipient is, in the exercise of reasonable efforts, in a position of self-support.'”
Thompson v. Thompson, 495 A.2d 678 (R.I. 1985).
Since alimony is usually awarded for a fixed period, the parties can make a reasonable determination of the “present value” of the total alimony that will be paid and calculate a lump sum to pay from retirement funds instead. If the money is transferred from one spouse’s retirement account, such as a 401k, into the other spouse’s retirement account, neither party will pay taxes on the transfer. If the receiving spouse needs the money for living expenses or to purchase a new home, for instance, the receiving party will pay taxes at their lesser tax rate on the liquidated amount. However, they will not pay the usual 10% penalty incurred before the age of 59 1/2 because the penalty does not apply if the transfer and/or liquidation is done pursuant to a divorce decree.
3. The new tax rules will restrict the way the alimony recipient can save for retirement.
Since the alimony received will now not be considered taxable, earned income, the spouse receiving alimony won’t be able to invest that money in an IRA. That can severely limit the amount of money that spouse can invest for their retirement. However, it won’t prevent the spouse from investing in a non tax deferred Roth IRA, for instance, but it does restrict the spouse’s options.
The new alimony tax laws aren’t devastating, but they do require more thought and analysis. Please contact us if you would like to know more.
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