06 Nov Tax Implications of Alimony
Alimony Tax Implications
Alimony, “spousal support” or “separate maintenance payments”, could have significant tax implications whether paid or received. Generally, the payer may deduct spousal support from his or her income, and the recipient must report alimony as taxable income. As a result, a divorce attorney might consider the following options when negotiating alimony:
Agree to Nondeductible/Nontaxable Maintenance
The parties may agree to consider spousal support as maintenance and not alimony for tax purposes. Therefore, the spousal support is nontaxable and nondeductible, just as child support. Such an agreement must be established in the marital settlement agreement approved by a judge. (Note, the recipient must include a copy of the divorce instrument each year on his or her tax return to claim the exemption and could not file electronically. See IRS Publication 504, Divorced or Separated Individuals; 26 U.S. Code § 71(b)(1)(B) (2106).) Given this option, most recipients would elect nontaxable alimony.
So why wouldn’t more people elect tax free income in the form of alimony? The payer is often making a higher income and looking for deductions. Nonetheless, a nontaxable/nondeductible arrangement could be more appealing if the paying spouse does not need the tax deduction or the rare case where the receiving spouse is in a higher bracket than the paying spouse.
Agree to Offset Large Tax Savings
In a scenario where spouses’ incomes are dramatically disparate, the payer spouse most likely receives a significant tax savings as a result of an alimony deduction. An argument can be made that the payer should pay the tax obligation of the recipient, which is more consistent with inequality of income distribution and ability.
Anticipate Taxable Income
For the spouse receiving alimony, he or she should anticipate the tax consequences early on because the payer spouse is not withholding taxes like an employer would. If alimony is the only source of income, a wise option is to pay an estimated tax each quarter to avoid a large lump sum payment at the end of the year. If the recipient has a job, increased withholding each paycheck could lessen the tax hit.
Avoid “Recapture” and Nondeductible Payments
The IRS is concerned with spousal support payments for about three years after a divorce. They are looking for any property distribution or post-divorce obligations hidden as spousal support for the benefits of income deduction. A higher alimony payment following divorce that lessens over later years is a red flag, especially a dramatic drop in years 2-5. If alimony payments are deemed to be in lieu of nonsupport items, the IRS can “recapture” taxes retroactively. Additionally, do not link payments terminate dates to a significant event for a child (e.g., an eighteenth birthday, high school or college graduation, etc.). These payments can be considered child support payments, which are not deductible.
Financial considerations during a divorce can be overwhelming. Consult an attorney and tax professional for help with the consequences of spousal support. Contact us here.