With the Tax Cuts and Jobs Act (TCJA), Congress made many changes to the tax code. In family law, perhaps the most significant change involved maintenance, or spousal support.
Prior to the TCJA, a spouse ordered to pay maintenance could deduct all those payments pre-tax on federal income, while the spouse receiving maintenance has to pay tax on the amount received. Because the spouse paying maintenance almost certainly had a higher marginal tax rate, the deduction had the net effect of increasing the net marital income post-divorce.
After the TCJA, the effect is reversed – the spouse paying maintenance no longer has the tax deduction but the spouse receiving maintenance no longer has to pay tax on maintenance, so the net effect is a reduction in net marital income post-divorce.
Parties looking at divorce after the TCJA went into effect began to worry about the ability to pay maintenance without the tax deduction. For example, a spouse earning $200,000 per year and ordered to pay $40,000 per year in maintenance would have been able to deduct pre-tax that sum, resulting in a savings of roughly $16,000 that could help pay the maintenance owed. Now, absent the deduction, the same spouse not only loses the $16,000 savings but also is taxed that additional $40,000 at a higher marginal rate. Instead of the court ordering a payment of 20% of gross income, the court really ordered closer to 25-30% of net income – a sum that makes paying maintenance overall more burdensome and trickier to calculate.
After a year of life under the TCJA, many spouses have looked for alternatives to maintenance.
The most popular strategy is an unequal division of property. One spouse agrees to receive more of an IRA or 401(k) and in that way has significant guaranteed retirement income. If that spouse needs to access some of those funds for living expenses, that spouse could borrow against the retirement asset at much less overall tax effect than if the higher-earning spouse paid maintenance, and the initial transfer is tax-free. A higher-earning spouse could also agree to transfer yearly for a set number of years a specific sum to the spouse, tax-free, and that spouse could access it early and the withdrawal penalty and tax would be less than if the higher-earning spouse had to pay maintenance.
These are just two creative workarounds. Spouses could also buy a rental property with a fixed income stream equal to maintenance to avoid taxes eating away at the overall net marital income or asset.
Creativity and awareness are the important strategies necessary to make alternatives to maintenance work under the TCJA.
If you have questions about maintenance and the TCJA, contact us – we can help.