How To Minimize The Loss Of The Alimony Deduction Under The New Tax Law

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Under the Tax Cuts and Jobs Act (TCJA) enacted in 2017, Congress eliminated many deductions taxpayers found valuable. Perhaps the most prominent deduction that disappeared was the one for alimony (or what Missouri calls maintenance). Before the TCJA, a spouse required to pay spousal support could deduct all of those payments from that spouse’s gross taxable income. In this way, the tax code expanded net family income and expanded the amount available for spousal support. As an example, if a spouse paid $50,000 in maintenance, under the old law, all of that would have been deductible, meaning a savings of roughly $20,000 in taxable income – money that can go toward the ability to pay more in maintenance. Under the current law, that benefit no longer exists; as a result, net family income for divorced families has shrunk.

Courts are aware of the change in the law, and some will take that into account when determining what amount a spouse can afford to pay in maintenance. If so, the court might well lower the amount of maintenance a spouse needs because it takes too much of the total net income of the paying spouse.

Divorcing couples can still maximize their net family income and assure that a spouse requiring support receives the support needed. Two strategies could be very helpful and work best in planning a settlement.

First, to offset some spousal support classified as maintenance, a paying spouse could agree to pay a lesser amount of actual maintenance but agree to make yearly transfers from a retirement account into the recipient spouse’s retirement account (or one division of a retirement account at an unequal rate). In this way, the recipient spouse receives a large sum tax-free to both parties (the recipient spouse will be taxed once those sums are spent). Because retirement accounts have penalties for early withdrawal, it is best if those transfers stay in the account and earn more than their withdrawal rate. But even if a spouse needs those funds, a withdrawal at 10% with minimal income tax consequence to the recipient is a net win for the family, because the same sum paid as maintenance would have cost the paying spouse much more than the 10% loss.

Second, spouses who own stock can exploit the capital gains tax minimum. Currently, to pay capital gains tax, a person must have an income of at least $40,000 to pay capital gains tax. Consequently, the higher-earning spouse could transfer stock at the divorce (larger than the equitable distribution) as a form of maintenance that ends up tax-free to both parties.

You might be wondering how this could help if you do not have stock to sell or retirement accounts to unequally divide. In that situation, the maintenance sums will likely be lower and it serves the recipient spouse to seek more in the property settlement to offset losses in maintenance. It may be in both spouses’ interest, for example, to sell the marital home and have the spouse receiving maintenance have a larger share of the proceeds to use as maintenance (this may have tax consequences, but a financial planner could help with suggestions to minimize). The simple point is that asset distribution, usually equal, may make more sense as unequal to avoid the maintenance tax penalty.

If you have questions about spousal support and the new tax law, contact us – we can help.

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