taxes

Divorce Alert: Tax Bill Targets Alimony Deduction

Written into the fabric of the GOP tax proposal is a change in how alimony is taxed. People paying alimony could lose "the greatest tax deduction ever." And that could ultimately affect those receiving alimony, too.

Since details of the new tax overhaul bill were released on Nov. 2, people of all income levels and ages have been trying to figure out how they could be affected going forward. One group of folks not likely to be happy: those paying alimony.

Section 1309 of the House bill would eliminate the deductibility of alimony. Killing the alimony deduction is one of the smaller revenue targets for the House Republican tax bill, yet it is exceedingly significant to the people affected.

Under current rules, alimony payors may deduct their payments from their taxable incomes, thus lowering their income taxes. In return, recipients pay income taxes on their alimony income. Because payors are usually in higher tax brackets and recipients in lower tax brackets, families can save money on taxes by shifting the tax burden to the lower earner. The saving can help increase cash flow for divorcing couples. They can then decide how to allocate the savings: to the payor or the recipient … or the court can do it for them.

According to the House, abolishing the alimony deduction would not be a large revenue generator. Over 10 years it raises only about $8 billion. That is because the tax increase on payors is offset by a tax decrease for recipients. For them, alimony income would no longer be taxable.

This wrinkle could have a significant impact on divorce settlements. For many payors, saving taxes on alimony payments is the one pain relief that comes with making the payments. According to John Fiske, a prominent mediator and family law attorney, “Alimony is the greatest tax deduction ever.” Without the deduction, payors will find it much more expensive and more difficult to agree to pay.

For example, in Massachusetts alimony payors usually pay 30% to 35% of the difference in the parties' incomes. For a payor in the 33% federal tax bracket, the House tax bill increases the cost of alimony by nearly 50%.

The entire set of laws, guidelines and practices around alimony are based on its deductibility. Passage of the House Republican tax bill is likely to lead to a mad scramble in the states to change the laws and guidelines to adjust alimony payments downward to make up for the tax status change.

The likely net result: Although recipients would no longer pay tax on alimony income, it is likely to reduce their incomes even further as divorce negotiations take the new, higher tax burden on payors into account.

About the Author

Chris Chen, CFP®

Founder, Insight Financial Strategists LLC

Chris Chen CFP® CDFA is the founder of Insight Financial Strategists LLC, a fee-only investment advisory firm in Newton, Mass. He specializes in retirement planning and divorce financial planning for professionals and business owners. Chris is a member of the National Association of Personal Financial Advisors (NAPFA). He is on the Board of Directors of the Massachusetts Council on Family Mediation.

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