Note: This post – unnecessarily inflammatory title and all – is specifically for people who have high income or assets and are in the process of a divorce. All others may be substantially bored and should read something more entertaining, instead, like the story of my Vigilante origins or my attempt to be poetic with whiskey. I promise, irreverence will return!
Marriage is undoubtedly your most important investment, emotionally, spiritually, physically – and financially. The average cost of a divorce in the United States is $15,000 in legal fees alone – and that’s $15,000 per party, in a matter where legal fees are typically not the biggest financial loss to either party. And yet, one unsung part of the new tax law aims to make some of those other losses potentially tens of thousands of dollars more costly, to the benefit of no one but our good ol’ Uncle Sam!
Under the Tax Cuts and Jobs Act, alimony will be taxed to the payor rather than the recipient.
Sounds like no big deal to people who receive alimony,1 right? Maybe even a new benefit? Not necessarily!
Some background about alimony is necessary to understand the change this causes in divorce law everywhere. Alimony is a bit unique. It is not an automatic right, but rather a negotiated or ordered form of relief in certain unusual situations. And it comes with a stigma in our culture: Nobody wants to pay alimony, some people don’t want to receive it, and the mere mention of the word can sometimes blow up an otherwise friendly negotiation.
Perhaps to the surprise of most of the public, though, divorce attorneys have sometimes found it advantageous to our clients to voluntarily make alimony payments, usually in lieu of immediate distribution of assets. This was typically due to the tax treatment of that payment: In 2017 and prior years, alimony was a tax deduction for the payor and taxable income to the payee.
Some divorces were amicably settled – avoiding costly legal fees and lots of stress for all involved – thanks to a wise attorney suggesting that a less-wealthy client forego a bit of immediate distribution in exchange for some alimony, which would reduce the taxable income of the more-wealthy client and leave both parties a little better off than other reasonable asset divisions would have left them.
Thus alimony – counterintuitively – could be used to keep the peace in one of the most difficult times in a client’s life!
But now those days are gone – and they were exchanged for higher tax revenue. And since every percentage of additional tax matters when life is a round of golf, FIRE couples need to be extra careful who they hire to represent them!
How does this increase revenue?
At a glance, Congress’s motivation to change the rule may seem a bit confusing. One person was not taxed on the income, but the other one was; wasn’t the old rule revenue-neutral?
Most payors of alimony are in high tax brackets – typically, above 30% marginal rates, even with the new, lower brackets. The tax rates of alimony recipients, of course, tend to be lower – otherwise, they would not be likely to collect alimony. Thus, the IRS would collect something like $.15 where it would otherwise have collected upwards of $0.30 if not for the transfer of wealth through alimony.
The parties “won” at the expense of the IRS: basically, they’d be transferring that dollar one way or another, but it was nice to transfer it while paying $0.15 less in taxes overall. And since the payor would see some financial benefit from the alimony, the payee was sometimes able to negotiate a higher payment than he or she otherwise would if the alimony were taxable income to the payor.
If that’s confusing, think of it this way: Under the prior rule, each dollar paid in alimony cost the payor less than $1.00 due to the tax savings. If the marginal tax rate was 36% for that payor spouse and 10% for the payee, the payee could reasonably ask for, say, 13% more in alimony to split the tax savings.2 This example would leave the payor roughly 23 cents per dollar better off3 than if he or she were taxed on the alimony, and would leave the payee roughly 3 cents per dollar4 better of than if he or she had no leverage over the payor to negotiate a higher payment – leverage which is now eliminated by switching the tax burden to the payor!
Tack onto that the loss of a potential divorce-settling, legal-fee-saving negotiation tactic, and the costs of divorce reasonably could rise for both parties in high-income, high-asset families.
Is this the end of alimony?
Alimony may be a much more difficult argument to make now. It may prove near impossible to convince a party to agree to an alimony payment, since it’s no longer a negotiating chip that can be beneficial to both parties and their families.
Thankfully, though, the new tax code does not change taxation of all forms of distribution, support, maintenance, and the like. So there remains some opportunity for workarounds that will benefit both parties, like “equitable reimbursement” or increased child support.
Family law attorneys – at least those worth their professional salt – will always be looking for creative ways to avoid this new treatment of alimony by using other methods of transferring wealth. Particularly if you have enough assets to say that you are a FIRE couple, this is your attorney’s job in forming a settlement offer.
The exact solution to the problem of increased taxes on alimony can take incredibly different forms depending on your state’s laws and the circumstances of your own case. But if you are going through a separation and expect to be paying alimony, make sure you choose your professionals wisely so you don’t end up giving Uncle Sam too big of a cut!
- Before we get into the nitty gritty of this post, I want to clarify our goal: We will talk specifically about alimony. Many other payments – like spousal support – will also be treated differently for tax purposes beginning in 2018. But these other payments serve vastly different purposes, have different rules, and are still going to happen regardless of any new tax rules. So they simply aren’t as interesting to talk about. If you have concerns with the tax treatment of any payment you make or receive, contact your attorney!
- 36% – 10% = 26% / 2 = 13%
- 36 cents saved in taxes – 13 cents in higher alimony = 23 cents. Of course, paying a bit more in alimony would mean a bit more in tax savings, so the payor would benefit by a little more than 23 cents in this example.
- The payee would collect 13% more in alimony, but pay 10% in tax. Due to the increase in income from that additional 13%, there’s an additional few dollars taxed, meaning the actual tax burden to the payee would eat up a bit more than 10% of the original alimony amount. But that still leaves the payee better off by nearly 3%, which can easily mean hundreds or thousands of extra dollars in income per year, courtesy of Uncle Sam!