Great news for the alimony recipient? Not necessarily.
Consider the following example: When Jane and John got divorced in 2017, John's income was $250,000 per year, and Jane was a stay-at-home mom with no earned income. John agreed to pay Jane $3,000 per month in alimony. Since he was able to deduct that amount from his income, his monthly out-of-pocket cost for the support was $2,130. Jane, of course, had to pay income taxes on the alimony. After paying taxes, however, her net ($2,400 per month) was greater than the out-of-pocket cost to John. This was an effective way to shift income from a high bracket to a low bracket and give John an incentive to pay Jane more in support.
By comparison, eliminating this tax benefit takes more money out of the hands of the divorcing couple and puts it in the hands of the IRS. The payer doesn’t have an incentive to pay a penny more than his/her out-of-pocket cost.
Is there a workaround that could still provide couples with the advantage of shifting the tax burden from the high wage earner to the low earner in the context of alimony payments?
In some cases, the answer may be a surprising yes.
Let's look at the case of Brian and Julie, who are in the same financial position as John and Jane. Julie is requesting $3,000/month in alimony for 6 years. Her attorney suggests that the parties negotiate a lump sum buy-out on alimony from a pre-tax account. This would provide the same tax benefit (shifting income from a high tax bracket to a low bracket) that the alimony deduction would have provided. With the help of a financial advisor, they determine that $3,000 per month in tax-deductible alimony is equal to $200,869 in pretax, lump-sum dollars (this assumes a 3% discount rate). To satisfy his alimony obligation, Brian can therefore transfer to Julie $200,869 from his IRA or Qualified 401k plan via a Qualified Domestic Relations Order (QDRO).
By transferring the retirement assets, Brian avoids the income tax liability that is embedded in those assets. When Julie takes money out of the account, she’ll pay ordinary income taxes on any distribution, at her marginal tax bracket, just as she would have with taxable alimony payments. As long as she is at least 59 1/2 years old, she can immediately begin taking distributions without incurring a 10% penalty.
This strategy comes with some significant drawbacks. First, a lump-sum buyout means the award becomes permanent and non-modifiable. With traditional alimony, if Julie were to die before the end of six years, Brian’s alimony obligation would cease, so Brian might have unnecessarily pre-paid alimony. The same could be true if Julie remarried during the payment period, Brian became disabled, or future alimony was modifiable in any way.
Of course, another shortcoming to this strategy is that many couples don’t have access to a large lump sum in retirement assets.
The best candidates for this workaround are likely older couples who can defer their income needs to retirement, are at least 59 ½ years old and ready to begin taking annual distributions from retirement assets, and understand all the risks involved with pre-paying support.
As always, qualified and personal legal, tax, and financial advice is necessary before making any financial decisions in divorce.
**Local attorneys…to learn more about this strategy and other hot tips for 2019, mark your calendars for my educational seminar on January 30, 2019, at the Bloomfield Township library.