The Tax Cuts and Jobs Act (TCJA) of 2017 is altering the traditional divorce planning landscape. Wealthy individuals will be impacted the most by these changes, prompting many of them to expedite the divorce process in order to finalize their agreements before Dec. 31, 2018, when certain tax benefits will be eliminated. While there is speculation that the law, which sunsets in 2025, may be short-lived, there is still incentive to act now before a tax break for alimony payments disappears.
For new divorces that are finalized after Dec. 31, 2018, all alimony payments will be treated like child support payments, which are not deductible. Before, the alimony payor could deduct the amount of their alimony payments – no matter how large the amount was – from their income, and the recipient could pay a lower tax rate on their payments. (For more, see: Trump's Tax Reform Plan.)
Here are some of the direct impacts of changes to the tax code:
Reduced Tax Savings for the Payer
In the past, if you paid $100,000 in alimony payments in one year, that meant a $100,000 deduction. This deduction was figured prominently on the front page of Form 1040, making it easier for the payer to locate, and thus file, for the deduction. (Unlike other deductions, including those for mortgages, medical expenses, etc. where the payer has to jump to the second page of the form.)
Disproportionately Impacts Women and Children
Alimony payments are always made by the higher-earning spouse to the lower-earning one. One of the consequences of this law will likely be less money for the spouse receiving alimony. In most cases, the spouse receiving alimony is the woman. Only 3% of alimony recipients were men according to the 2010 census. Women are also at more risk of income decline after a divorce: this also has the effect of putting their children at risk. (Recipients claimed $9.2 million in payments in 2013 on their tax returns.)
Under the current code, the higher paying spouse would often attempt to negotiate a higher payment, especially if there was a significant difference between income earned, so they could deduct more from their income at the end of the year. With the elimination of this provision, the higher paying spouse may not be willing to make as large of payments.
Suspension of Dependency Exemptions from 2018 to 2025
Prior to the changes in the tax code, the parent claiming a child as a dependent (the custodial parent) would qualify for the dependent exemption. This tax exemption was significant: $4,050 per child. If that parent was in the highest tax bracket (39.6%), the total tax savings for each dependent would be $1,604. With the elimination of this exemption, negotiating child support will be more difficult because there is less monetary incentive for both obtaining custody and claiming a child as a dependent.
Child Tax Credit Increase
The amount of the Child Tax Credit (CTC) awarded to parents has increased. Through the CTC, the government awards families that have children with a direct tax deduction. If a family does not have any tax liability, they may still qualify for a partial refund. In 80% of such cases, women are granted sole custody, so in the divorce process, the parent awarded custody – more often than not the mother – will benefit from a reduction in taxes as a result of the CTC.
While the suspended dependency exemption may reduce tax benefits for some families (and custodial parents), a tax credit like the CTC is more valuable than a tax deduction. A tax credit reduces your tax bill dollar-for-dollar. For example, if you owe the IRS $4,000 for the previous tax year, and you qualify through the CTC for a $2,000 credit, this amount immediately cuts your tax bill in half. If you have two children and qualify for two credits, your entire tax payment for the year can be erased.
In addition, the CTC is a refundable tax credit, which is more beneficial than a nonrefundable credit. A nonrefundable credit will reduce your current tax payment; a refundable one gives you an additional refund even if you have no zero tax liability. For example, if your bill for that tax year is $1,000 and you have a refundable credit of $1,400, you will not owe any taxes and you will also get the difference of $400 back.
Not only has the amount of the CTC increased, the income threshold to qualify for the credit has been raised dramatically. Prior to the TCJA, if your adjusted gross income (AGI) was above $75,000 for a single person (or $110,000 for married couples who file jointly), you no longer qualified for the credit. Beginning in 2018, the income threshold for the CTC has increased to $200,000 for a single person, or $400,000 for married couples who file jointly. As a result of the TCJA, the benefits of the CTC have expanded beyond low-income households to include wealthy couples. This provision, unlike other changes to the tax code that may negatively impact high-earning divorcees, actually stands to benefit them.
Expanded Use of 529 Plans
Use of the 529 plan has also expanded as a result of the TCJA. A 529 plan is a savings plan that provides tax advantages when saving and paying for higher education. Prior to the TCJA, savings in a 529 plan could only be used for qualified college costs. Parents can now withdraw up to $10,000 from a 529 plan to pay for elementary and secondary school tuition.
In the past, during divorce negotiations, one parent could demand the other parent pay non-college education expenses out-of-pocket. With the new flexibility of a 529 plan, the parent responsible for all pre-college education expenses can use tax-advantaged savings rather than paying out-of-pocket.
Couples of All Income Levels Benefit From Strategizing
With divorce planning becoming more difficult in the coming years, couples may need to change their strategy to minimize tax penalties and maximize tax benefits during divorce proceedings. In a new era of divorce planning, both high net worth and low-income couples should consider how the TCJA will impact them and shoulder the burden together. An acrimonious divorce can have serious financial consequences, so finding a way to collaborate or finding a professional to help you mediate your negotiations is in your best interest.