While nearly every client understands that the 2017 tax reform legislation made sweeping changes touching nearly every corner of the tax code, many might not realize that the tax treatment of alimony payments was turned upside down—until they begin to consider divorce.

Clients considering divorce should be advised that the financial repercussions of that decision have shifted away from a system that previously allowed a former couple a larger total pool of assets via a tax system that recognized the need for those individuals to support two households using the same income. In a post-reform world, clients no longer have the luxury of relying upon the tax code to ease the burden of dividing income among two households—instead, clients should be advised to consider more creative strategies to asset division in divorce in order to minimize the two former spouses’ overall tax burden.

Alimony, Pre- and Post-Tax Reform

Prior to tax reform, alimony payments made from one former spouse to another were deductible for the payor spouse and taxable to the recipient spouse. Tax reform essentially reversed the treatment, so that alimony payments are no longer deductible and no longer taxable income to the recipient.

Upon first glance, clients might not see how this could impact them in divorce planning. The previous system, however, usually allowed the higher earning spouse a significant tax deduction while shifting the taxability of the same income to the lower earning spouse—who would presumably be in a much lower-income tax bracket. Because of this treatment, the former couple would overall have access to a larger pool of combined income than would be available were the entire income pool taxed at the higher earning spouse’s tax rate.

Post-reform, typical cash alimony payments will be much less advantageous—because there is less to work with in the first place, alimony payments may simply be lower in many cases. The fact that the recipient will no longer owe taxes on the alimony may ease this burden to an extent, but in general, the two spouses will each have less because the income will be taxed at the payor’s higher income tax rate.

State tax systems vary post-reform—while some states continue to allow the payor’s deduction at the state level, others have aligned with the federal tax treatment of alimony post-reform.

Post-Reform Planning Strategies

Despite the generally unfavorable shift in the tax treatment of alimony payments, couples considering divorce post-reform can engage in a number of creative strategies in order to reap some tax benefits and ease the overall burden of maintaining two households. In some cases, clients may wish to consider making use of retirement accounts that have been funded with pre-tax dollars in lieu of higher alimony payments.

Using this strategy, the recipient spouse will, as prior to reform, be required to pay income tax on the retirement assets upon withdrawal but will receive the pre-tax value of those funds.  Depending upon the client’s age, the 10 percent early withdrawal penalty for withdrawals before age 59 ½ may need to be considered, and the clients should likely use a qualified domestic relations order (QDRO) to transfer the retirement assets. For small business owners, this strategy may be particularly effective, as they can use the funds they would otherwise pay in alimony to make large contributions to replenish the depleted retirement account.

Charitable remainder trusts (CRTs) can also offer a tax-preferred transfer strategy. CRTs are funded with an initial payment and then pay out income periodically to the beneficiary, with the remainder going to charity at the end of a predetermined period. The payor spouse who funds the CRT will get a deduction for the initial funding and the income will be taxable to the recipient spouse at his or her lower-income tax rate—essentially allowing a mechanism to obtain pre-reform alimony tax treatment.

Transferring investments with large built-in gains from the higher income spouse to the lower income spouse can also generate significant tax benefits, as the lower earning spouse may be able to sell the asset and realize the gain without paying tax on that gain in some cases.

Conclusion

While use of tax planning strategies to minimize the tax burden of alimony can require increased cooperation and communication between the spouses during the divorce process, advisors should work to help clients understand that this creative planning can leave both spouses in a better financial position than simply relying upon traditional alimony payments post-reform.