If you’re divorced or in the process of divorcing, be sure you understand how the Tax Cuts and Jobs Act (TCJA) affects the tax treatment of alimony. For most couples, the tax cost of divorce will go up next year.
Under current rules, a taxpayer who pays alimony is entitled to a deduction for payments made during the year. The deduction is “above-the-line,” which is a big advantage, because there’s no need to itemize. The payments are included in the recipient spouse’s gross income.
The TCJA essentially reverses the tax treatment of alimony, effective for divorce or separation instruments executed after 2018. In other words, starting next year, alimony payments will no longer be deductible by the payer and will be excluded from the recipient’s gross income.
Existing divorce or separation instruments, including those executed during the remainder of 2018, aren’t affected. Current rules apply even if an instrument is modified after 2018 (unless the modification expressly provides that TCJA rules apply).
What’s the impact?
The TCJA will likely cause alimony awards to decrease for post-2018 divorces or separations. Paying spouses will argue that, without the benefit of the alimony deduction, they can’t afford to pay as much as they could under current rules. The ability of recipients to exclude alimony from income will at least partially offset the decrease, but many recipients will be worse off under the new rules.
For example, let’s say John and Lori are divorcing in 2018. John is in the 35% federal income tax bracket and Lori is a stay-at-home mom who cares for the couple’s two children. The court orders John to pay Lori $100,000 per year in alimony. John is entitled to deduct the payments, so the after-tax cost to him is $65,000. Presuming Lori qualifies to file as head of household, and the children qualify for the full child tax credit, Lori’s federal tax on the alimony payments is approximately $8,600, leaving her with $91,400 in after-tax income.
Suppose, instead, that John and Lori divorce in 2019. John argues that, without the alimony deduction, the most he can afford to pay is $65,000, and the court agrees. The payments are tax-free to Lori, but she’s still left with $26,400 less than she would have received under pre-TCJA rules.
The current rules essentially shift income recognition from the paying spouse to the recipient, reducing the couple’s overall tax liability (assuming the recipient is in a lower tax bracket). The new rules eliminate this tax advantage. Of course, in the event that the recipient is in a higher tax bracket than the payer (an uncommon but not impossible situation), a couple is better off under the new rules.
What if you’re already divorced?
The new rules won’t affect existing divorce or separation instruments, even if they’re modified after 2018. However, spouses who would benefit from the TCJA rules — for example, because their relative income levels have changed — may voluntarily apply them if the modification expressly provides for such treatment.
If you’re contemplating a divorce or separation and would benefit from the alimony deduction, act quickly to ensure that it’s finalized before the end of the year. If you’re already divorced or separated, determine whether you would benefit by applying the new rules to your alimony payments. If you would, a modification of your divorce or separation instrument may be in order.