Divorce and the New Alimony Tax Change

Starting in 2019, alimony will no longer be deductible by the payer and taxable to the receiver.

I wrote the following example to a journalist who was looking to examine the impacts of the new law.

The new tax law hurts divorced people because it (usually) pushes more income at the person in the higher tax bracket. However, with some clever planning, the effects can be mitigated. The big opportunity that should be considered for those getting divorced in 2019 is considering an asset-split favoring the spouse to receive the alimony in exchange for a lesser amount of alimony than in an even split.

Being collaborative in the divorce process and being willing to be creative with the asset division and alimony agreements will be more important than ever to reduce taxes and make both people better off.

Scenario 1

  • Bob and Jane are 60 years old.
  • Bob is in the 35% Federal tax bracket.
  • Jane is in the 24% Federal tax bracket.
  • Bob pays Jane $25K per year for the next ten years in alimony.
  • Bob and Jane split a $1 million 401(k) (pre-tax, which is important).

Bob ends up paying tax on $25K * 10 years’ worth of income before paying it to Jane, so he is paying $250K + $87.5K (35%) for a total of $337.5K out. He’s receiving $500K of the 401(k).

Jane receives $250K in cash and $500K of the 401(k).

Results:

  • Bob:
    • Cash on hand:
      • -$337.5K
    • 401(k)
      • $500K
  • Jane:
    • Cash on hand:
      • $250K
    • 401(k)
      • $500K
  • IRS:
    • $87.5K

Scenario 2

  • Bob and Jane are 60 years old.
  • Bob is in the 35% Federal tax bracket.
  • Jane is in the 24% Federal tax bracket.
  • Bob and Jane agree to no alimony.
  • Jane receives $835K of the 401(k) and Bob receives $165K.

This time let’s start with Jane, since her situation is more straight forward. She must distribute $33K per year from her 401(k) to get the equivalent of the $25K of alimony she was receiving (since at her $33K distribution will bring an $8K tax bill at 24% [I’m rounding]).

  • Jane:
    • Cash on hand:
      • $250K
    • 401(k)
      • $505K ($835K minus $33K * 10 years if you’re keeping score at home).
  • IRS
    • $80K ($8K per year times 10 years).

Bob is a little more complicated, so follow me here. He takes the $33.75K that he was giving to Jane and the IRS each year in the prior scenario, and puts it into retirement accounts (e.g., 401(k) – let’s ignore the fact that the limit per account is $24.5K for employee contributions for ease of calculation here – if he’s self-employed or has two retirement plans he’ll be able to do it, and even if he can’t get all the way to $33.75K, there will still be some net benefit to be had).

  • Bob:
    • Cash on hand:
      • -$337.5K
    • 401(k)
      • $502.5K ($165K plus $33.75K * 10 years)

A little shuffling around, and we’ve created $7.5K of extra value in Bob and Jane’s 401(k)s from what the IRS would have gotten.

I’ve simplified a few pieces here, but you can see how, especially with a bigger tax rate differential, there are opportunities to push taxes to the spouse in lower brackets through other means that can be a win-win for both parties.

Of course, you have to be fairly collaborative to make this kind of agreement happen. So the losers are likely going to be those going through bitter divorces who will just split everything 50/50, and the winners will be the IRS.

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