Posted by Hakyun Morrissey.
The TIAA group of companies and its employees do not offer tax or legal advice. You should consult an independent tax or legal advisor for advice based on your own particular circumstances.
Three kids. Two cars. A shared income. Divorce has the potential to fracture what you have lovingly built as a couple. Though it can be a gut wrenching time, it’s essential that you overcome the emotion of the moment to focus on the financial implications and protect what matters most—the family unit, or simply the nest egg you and your spouse created together.
The Tax Cuts and Jobs Act, passed by Congress in December 2017, could have a major impact on couples who get divorced after December 31, 2018; specifically, on divorce settlements that include a provision for alimony payments (also known as spousal support or maintenance).
For divorces finalized before 2019, spouses who agreed to pay alimony to their ex can deduct cash payments for federal income tax purposes. Depending on the size of the payments, this is a potentially huge tax break—currently enjoyed by about 600,000 taxpayers.1 For post-2018 divorces, this deduction is no longer available.
Under the old law, the spouse receiving spousal support had to report all payments as taxable income. Now, alimony will generally be considered tax-free income. This may sound like a big win for women (who still make up the vast majority of those awarded spousal support). However, there are two big reasons why the new law could potentially hurt rather than help newly divorced spouses who count on alimony to get by financially:
- You can only use taxable earned income to invest in an IRA, so going forward, if you want to use a portion of your alimony payments to save for retirement, you will have to do so through a taxable account rather than an IRA or 401(k). Someone receiving alimony as well as earned income through part-time work would, therefore, be wise to take full advantage of any workplace retirement plan she is eligible for.
- The elimination of the alimony deduction may also potentially hurt lower-earning divorcing spouses because in past divorce settlements, it was a kind of bargaining chip. The party seeking alimony was better able to negotiate a higher payment when the payer was in the position to fully deduct that amount from his or her income.
Work with your spouse to find a workaround
If you have assets other than cash on the negotiating table, you and your spouse (and of course, your own tax advisor) could find a workaround. For example, the effects of the new law may be offset by transferring retirement funds instead of cash. In other words, instead of withdrawing cash for alimony payments (and having to pay tax on those withdrawals), a divorced spouse can make a lump-sum alimony payment in the form of a retirement account. The spouse receiving the retirement funds will have to pay tax when withdrawing the money, as with any IRA or 401(k) withdrawal—and the 10% early withdrawal penalty may apply if withdrawn before age 59½—while the spouse handing over the IRA is getting a tax break by giving money he or she would otherwise have paid taxes on.
What if you can’t wait until retirement?
Obviously, a spouse younger than 59½ who is banking on nearer-term alimony income won’t want it locked up in a retirement fund. And the other spouse won’t necessarily want to play fast and loose with their retirement savings and jeopardize their future security. You and your spouse can work with your tax advisor to find a mutually beneficial solution—perhaps a combination of cash payments and retirement assets. If the receiving spouse has other income to live on until retirement, an “alimony IRA” could be highly desirable. It has the potential for tax-deferred growth, eventually providing a nice source of retirement income.
Double down on the house? Not so fast…
Instead of alimony payments, you and your spouse may decide, on top of splitting tax-deferred retirement accounts, to negotiate harder for that most cherished of assets: Your house. But tread with caution: The new tax law changes also affect property taxes, which may have some bearing on your home’s actual value. Under the new law, the amount you can deduct in property taxes and mortgage interest has been reduced, essentially increasing the price of home ownership. You will want to factor that in when weighing your marital assets during divorce. Again, collaboration is key for minimizing the tax burden on both sides.
Happily married? Review your pre-nup
In financial planning, we plan for 10, 25, even 50 years out. Even if your marriage is solid as oak, it may be worth revisiting your pre-nuptial agreement, if you have one, since any included alimony provisions would have taken the tax break for granted. And although this tax reform is a big deal, the tax code may undergo yet another big transformation in 2026 (the new tax law covers 2018-2025). Therefore, your financial plan needs to figure in future tax changes as well as your current tax situation. If there’s divorce income you might be counting on over the long term, consider the tax implications over the next seven years, but also 10 years, when the tax landscape may shift again dramatically—changes that may be good (for you) in some ways, bad in others.
Alimony, like most money transfers, will always have tax implications. If your marriage is on the rocks, a tax specialist becomes just as indispensable as a divorce attorney. Because payments are often large, divorcing taxpayers (on both sides) are smart to find the most tax-advantaged way possible to give and receive alimony payments. The key thing in divorce is being collaborative with your spouse to maximize the long-term financial outlook for both of you.