Why the Latest Tax Changes Could Incentivize Divorce this Year
If you’ve ever had to go through a divorce, you know just how painful the process can be. And unfortunately, our country’s recent tax code changes are likely to make the already miserable experience of getting divorced even worse.
Although taxes aren’t typically top-of-mind when your marriage is falling apart, the U.S. tax code has contained clauses pertaining to divorce for decades. And regrettably, the latest tax changes rolled out in December will soon impose additional burdens on divorcing couples - at a time when greater hardship is the last thing they need in their lives.
On December 22, 2017, the tax bill that was signed into law created a penalty that will negatively impact some couples who choose to get divorced. The change, slated to take effect in 2019, will allow the federal government to rake in more than $8 billion in revenue over the next 10 years by requiring that some parties to future divorces pay more than they had to in the past.
If there’s any saving grace to the new legislation, it’s that this tax penalty will not apply to all divorces, but only those involving alimony.
Alimony or spousal support - the payments that a divorcé(e) makes to their ex-spouse who earns less money - doesn’t come into play in every divorce scenario. If the divorcing parties have relatively equal incomes, for example, then spousal maintenance likely won’t be applicable.
But in situations where one partner makes substantially more money than the other, alimony can be used as a means of providing support to the lower income partner so they aren’t unfairly disadvantaged by virtue of the divorce.
For the past 75 years, under the tax code, alimony has been deductible for the payer; so the individual paying spousal support has been able to deduct those payments from their federal income taxes. And the alimony recipient has had to pay income taxes on any money received.
Since the person receiving alimony payments usually fell into a lower tax bracket than the ex-spouse who made the payments, and since the recipient was the party that got taxed under this paradigm, less money ultimately got allocated to the government than if the payments had instead been taxed upfront.
Under this historic model, divorce attorneys and mediators have been able to take advantage of the alimony tax deduction to help reach settlements in divorce scenarios because the deduction meant there was more overall money in the mix that could be allocated between the parties.
However, under the new Tax Cuts and Jobs Act, beginning on January 1st, 2019, alimony will no longer be tax-deductible for the paying party, and any payments received by the recipient will no longer be taxed as income. In other words, the new law shifts the tax burden from being on the alimony recipient to being on the alimony payer.
And at first glance, that may sound like a good thing. After all, shouldn’t the person with more money get taxed as opposed to the person with less money?
But there are several reasons why the new legislation might not be as beneficial as it seems.
(1) The new law is likely to further complicate the divorce process.
Family law attorneys and mediators have expressed concern over the impact that the new tax treatment of alimony could have on settlement negotiations. More specifically, they worry that the new law will render the issue of spousal support more contentious than it was previously and could therefore lead to more protracted battles between divorcing couples.
By making negotiations tougher and settlements more difficult to reach, this legislative change is likely to result in the divorce process becoming more expensive and drawn-out, negatively impacting both parties involved.
(2) The federal government is the primary beneficiary of the new arrangement.
This new approach will end up increasing the amount of taxes that the government receives from divorces involving alimony because the party paying maintenance to their ex-spouse typically has a higher income and tends to fall into a higher tax bracket than the person receiving the payments. Consequently, that individual will have to pay taxes on the alimony they give to their ex in accordance with their higher tax rate (which also means there will ultimately be less money to go around when it comes to negotiating the final divorce settlement).
(3) The new legislation may reduce the amount of spousal support that gets paid out.
The theory here is that the amount of alimony that gets contributed will decrease since a proportion of it will now be going toward taxes instead of to the payout recipient.
Under the laws that have been in place to date, the higher-earning spouse in a divorce scenario was incentivized to offer more support to their lower-income partner because they were able to deduct those maintenance payments. However, once the new legislation takes effect, there’s a concern that alimony payers may be more limited in their ability to pay alimony after their other fixed expenses have been taken into account since a portion of it will now need to go to the government.
The new tax treatment of alimony payments could prove to be especially onerous in its effect on lower-income couples, for whom higher taxes on alimony payouts will be less affordable in light of their other monthly fixed costs and their lower proportion of expendable income. Having a chunk of their alimony payments taken for taxes may have a real impact on their quality of life.
Given the potentially negative consequences of changing our tax treatment of alimony, it begs the question: apart from the obvious fact that the government stands to financially benefit from the new law, why would lawmakers put something in place that could result in these otherwise undesirable outcomes?
The answer probably isn’t that surprising. Lawmakers have found the move to be justifiable from a policy perspective because the new law will serve to disincentivize divorce.
Though not always overtly, the government has historically leveraged the tax code to incentivize marriage and disincentivize divorce. In general, married couples tend to receive favorable tax treatment under our system.
But regardless of how you feel about the government playing such a hands-on role and attempting to use the tax code to drive our society’s behaviors, the upcoming change to how alimony will be taxed means the government will be taking money from a couple at a time when they’re financially vulnerable. At a time when they’re struggling to figure out how they can afford to maintain their own separate households and begin building their own separate lives. And at a time when they’re still psychologically reeling from having just gone through one of the worst periods of their lives.
Moreover, while imposing this type of tax penalty may render couples more likely to “stick it out” and remain in their marriages, it could also have the unsavory effect of financially trapping them in unhappy, toxic, or even abusive relationships.
So if you are currently contemplating getting divorced, what does this mean for you?
Well, if alimony won’t be relevant to your situation, then this change shouldn’t negatively impact you. Breathe a sigh of relief!
And in those cases where alimony is likely to come into play, you might want to do what you can to expedite the process and get your divorce finalized by year-end to avoid being subject to the new law. While the recent tax legislation will apply to any divorce decrees that are issued after December 31, 2018, the change will not retroactively apply to divorces that occur prior to that date (nor should it impact anyone who is already paying alimony).
Finally, everyone’s financial circumstances are unique. So if you are concerned about how the latest tax code changes might affect you, I would highly recommend consulting a certified public accountant (CPA) or a certified divorce financial analyst (CDFA) to discuss your particular situation and determine what actions, if any, you should take.
At the end of the day, it’s important to remember that your marriage (and its dissolution) may be subject to forces that are outside of your control, such as the laws that our government sets forth. And when that’s the case (as it often is in life), all we can really do is inform ourselves and try to figure out the best path forward given the circumstances.