Most of the provisions of the tax reform bill that passed in late 2017 took effect at the beginning of this year. Between new tax rates and brackets, expansions of some deductions and credits and limitations on others, and a host of other provisions, many taxpayers will see big changes when they file their returns in the coming months.
However, there's one big change that won't hit taxpayers until the beginning of 2019. It won't affect everyone, but for the many people in the U.S. who are divorced, changes in how alimony payments get taxed could have a huge financial impact, given the roughly $10 billion in such payments that get made every year. With divorces running between roughly 800,000 and 950,000 annually since 2000, there are millions of people who might be able to benefit from some last-minute tax planning -- if they can cooperate effectively.
What's happening with alimony under the new tax law?
The tax law that applies through the end of the 2018 tax year makes a distinction between various payments that divorced spouses make to each other. Traditionally, divorce decrees have distinguished between alimony payments and maintenance payments between spouses, with child support payments made on behalf of their children falling into a third category. Although the net effect of both alimony and maintenance payments has been to move money from one spouse to the other, different tax treatment made one characterization preferable to the other in certain circumstances.
In particular, money that one spouse pays the other for maintenance or child support doesn't have any tax impact under current law. The receiving spouse doesn't have to treat the money as income, and the paying spouse doesn't get a deduction for the payment. Money that one spouse pays for alimony, however, does have tax consequences under current law. The paying spouse gets to deduct the amount of the alimony payment, with an above-the-line deduction that doesn't require the paying spouse to itemize to claim. In exchange, the receiving spouse must treat the alimony as taxable income.
What the tax law did was to change this treatment starting in 2019. For those who get divorced in 2019 or later, all payments between divorced spouses will be treated identically. There'll be no tax impact from any payment, meaning that the receiving spouse won't have to include payments as income, and the paying spouse won't get to deduct anything. That's a whole lot simpler, and it solves some potential fraud issues. But it does remove a planning opportunity for divorced spouses who are willing to work with each other.
2 cases to consider
In particular, there are two situations in which it'll be important for couples to act before the end of 2018. First, if you're in the process of divorcing, the timing of the final divorce agreement will be crucial. Specify alimony payments and get divorced on or before Dec. 31, and you'll have the option to effectively transfer taxable income from a spouse in a higher tax bracket to one in a lower tax bracket, saving on taxes overall. That in turn can make it possible for the paying spouse to make larger payments while still ending up ahead on an after-tax basis. On the other hand, if you wait until Jan. 1 to get divorced, that option won't be available any longer.
Second, if you're already divorced but the original agreement didn't include an order for spousal support, the law is ambiguous about how a subsequent order would get treated. Those who already have a spousal support order by the end of 2018 can retain the current-law tax treatment even if that order is modified in or after 2019. But there's at least some risk that a request for a first-time spousal support order would be treated as first having occurred in 2019 or later, taking away the option of having old-law tax treatment.
Finally, the new law does give divorced spouses who would prefer the new tax treatment to govern their pre-2019 divorce the option of agreeing to adopt the new rules. That's not necessarily a time-critical issue, as this election can be made at any time. But if circumstances have changed and it makes sense to treat payments between divorced spouses as having no tax impact, it may be that the sooner you do so, the better.
Worth a look
There are obvious reasons divorced spouses might not be able or willing to come to a quick agreement on making a move that could be tax-smart for both of them. Nevertheless, with the potential to unlock some net tax savings for both parties, divorced spouses might be willing to put their differences aside to keep a little extra cash out of the hands of the IRS.