Minimizing Taxes In Divorce Without The Alimony Deduction

As a quick basic example, a single breadwinning spouse has $500,000 of taxable income and pays the recipient spouse $150,000 alimony. A simplified calculation of the tax benefit under the old law is:

• Payor deducts the $150,000 at the 35% bracket saving the payor $52,500
• Recipient reports the $150,000 costing approximately $30,000 of tax calculated with the graduated ordinary income rates per the schedule below
• The net tax savings to the family under the old law was the difference of $22,500

So the question now becomes: what strategies can be used to replicate some of the prior tax benefits of alimony payments? The answer: be strategic in the division of assets in divorce. When dividing marital property, intuitively you may think each asset should be split 50/50. But when there is a differential between the highest tax bracket of the payor and that of the recipient, there is an opportunity for tax saving. Smart high-net worth couples should use these strategies to maximize how much they each keep in their pockets.
Fund Alimony By Transferring Retirement Accounts at Pre-tax Values

Depending on the couple's assets, ages and goals, it may make sense for a low-income earning spouse to take more retirement assets such as IRAs and 401(k)s in exchange for reduced alimony payments. This effectively could allow the breadwinning spouse to “make alimony payments” through a retirement asset. The payor funds some or all their alimony payment by transferring funds without ever paying pay tax on it. This results in paying with pre-tax dollars gaining the same benefit of the prior alimony tax deduction. The recipient spouse will have to pay tax on the retirement account withdrawal, but has more assets to draw income from and increased control. They own the assets no matter what happens rather than depending on the alimony payment which would be subject to restrictions including the risk of the payor’s death.

If the recipient is under age 59 1/2, it is important to understand the nuances of withdrawing from 401(k)s and IRAs to avoid a 10% early withdrawal penalty and what needs to be documented in the divorce agreement. There are special options for splitting pensions in divorce under a Qualified Domestic Relations Order (QDRO). If the recipient spouse is over 59 1/2, they do not have to worry about the 10% penalty.

This strategy can be particularly effective for a business owner or executive who can replenish the retirement plan assets by making significant tax-deductible contributions to retirement plans such as defined benefit or deferred compensation plans with the cash they otherwise would have had to use to pay alimony.Executives who are lucky enough to have vested funds already in deferred compensation, restricted stock or stock option plans with companies who will allow them to be transferred to a non-employee, should explore having these plans paid directly to the lower-income spouse. An additional strategy for business owners is to consider assigning non-voting, assignee or income only interests in real estate or a business in lieu of alimony. This is complicated and may require changes to company agreements but can be a very effective strategy.

Use a Charitable Remainder Trust (CRT)

A CRT is an irrevocable trust a person sets up and transfers assets to in order to reduce the amount of taxes they pay while ultimately helping a cause they care about. The trust pays taxable income to a beneficiary for a specified period and the assets remaining in the trust at the end get distributed to the designated charity.

For a payor of alimony who also has strong philanthropic values, utilizing a CRT to fund at least a portion of the alimony could be a beneficial tax strategy from a few perspectives. First, the breadwinner can get a tax deduction calculated based on the value of the contributed assets and specify their former spouse as the income beneficiary for the duration alimony payments are due. The annual income generated by the trust will be paid and taxable to the recipient spouse. Savvy couples can use the differences in the their tax brackets to save on their combined taxes and split the amount that they would have had to pay to the IRS.

The second level of benefit is that it can be funded with low basis investments. Once the appreciated assets are in the CRT they can be sold and diversified without any tax due on the gain. This alleviates the problem of trying to figure out which spouse gets stuck with low basis investments.

Be Strategic In Which Investments Each Spouse Takes In The Settlement

If the couple has large gains on any stocks, mutual funds or real estate, a lump sum transfer to offset alimony may be a smart solution. Single taxpayers can have up to $39,475 of taxable income and not pay any federal capital gains tax. They pay 15% from $39,475 to $200,000, 18.8% for amounts from $200,000 to $434,550 and 23.8% over $434,550 - see chart below. The rates over $200,000 include the 3.8% net investment income Medicare surtax.

A spouse with no taxable income could sell $100,000 of stock with a $39,000 gain and pay no tax while the breadwinner making $500,000 would have had to pay $9,282 on the sale. Therefore, a couple with a large investment portfolio could greatly benefit by transferring holdings with large gains to a low-income spouse. The payor can use their earnings that they would have used to pay alimony to buy more stock to replenish their portfolio.

In addition to the tax savings, it can be ideal to use a lump sum transfer in lieu of alimony as it eliminates the tension that ongoing alimony payments cause. This cleaner break can help each spouse move on more quickly. A recipient spouse does need to be aware that division of property payments are dischargeable in bankruptcy, but alimony payments are not. In addition, wage garnishment is lower with property division payments than with alimony. So if the property division is not done immediately at the time of divorce and there is any concern that a former spouse will not make the property payments, alimony may be a better option than receiving installment payments on a property settlement over a few years.

These strategies will not provide tax benefits for ultra-high net worth couples when both spouses are in the 37% bracket or for couples with middle income when both are in the 22% bracket. But couples with a differential between the payor’s highest tax bracket and that of the recipient can benefit greatly from being strategic in splitting assets in divorce. This is especially true for those millionaire couples with substantial income and enough money that they have choices, but not so much money they can afford to make mistakes. Most people’s displeasure from paying taxes makes the behavioral finance aspects of taxable income shifting valuable in any divorce negotiations regardless of their tax bracket.

The “divorce subsidy” from deductible alimony has always been a nightmare for the IRS to track which is part of the reason for the change - the main driver is to increase revenue for the government by taking away the deduction. The additional complexity of deductibility continuing to be allowed for divorces finalized before 2019 is prompting the IRS to add a question in 2020 and beyond to Schedule 1 of the Form 1040 asking taxpayers who claim a deduction for paying alimony to provide the date of their divorce.

While the elimination of the alimony deduction is permanent, we obviously never know when the law might change again. It's prudent to add provisions for tax law changes in your Marital Settlement Agreement (MSA) with specifics about what can be modified. Then if there is another change in the tax law, you can hopefully limit the modifications to alimony. There are other provisions in the new tax law that expire in 2025 that make keeping the marital home more expensive and taking the kids as tax exemptions less valuable. Couples with pre-nuptial or post-nuptial agreements should have their agreements reviewed to assess the impact of all the law changes. Given the complexity of all of these issues, it's critical to hire an experienced attorney with expertise in high net worth cases.

Every family’s situation is unique and there are typically many moving parts in a modern divorce settlement. Changing any one component often causes a ripple effect on the others. Altering the amount of alimony may change child support which may affect the division of the assets. While these strategies look great on paper to tax savvy attorneys, CPAs and Certified Divorce Financial Analysts, the complexity may cause more confusion and challenges in settling the case than the tax benefits are worth. But with careful divorce planning, astute couples can negotiate a win-win by giving less to the IRS.

What’s your strategy to keep money in your pocket and out of Uncle Sam’s?

No representation is being made that any strategy shown will or is likely to achieve results similar to those shown in this presentation. BDF does not provide legal, tax, insurance, social security or accounting advice. Clients of BDF should obtain their own independent tax, insurance and legal advice based on their particular circumstances. The information herein is provided solely to educate on a variety of topics, including wealth planning, tax considerations, insurance, estate, gift and philanthropic planning.