For years — decades — alimony payments were tax-deductible to the person paying alimony, and taxable income to the person receiving alimony.
Tax season is coming, so let’s take some time to review one of the biggest divorce topics: alimony.
We will answer the two biggest questions in divorce, alimony and your taxes:
- Is alimony tax deductible?
- Do you have to pay taxes on alimony?
Read: Tax Basics for Divorce
Alimony and Taxes
For years — decades — alimony payments were tax-deductible to the person paying alimony, and taxable income to the person receiving alimony. Under the 2017 tax law, now alimony payments are no longer tax-deductible for the payer, and they aren’t considered taxable income for the recipient.
To understand the impact of this on your family’s bottom line, you have to understand the basics of marginal tax brackets.
Marginal Tax Brackets and Alimony
Tax brackets confuse very smart people all of the time, so let’s spend a little time on a refresher so that you will really understand what you came here to learn: how alimony and taxes work.
In the United States we have marginal tax brackets. For example, there are seven federal tax brackets for the 2020 tax year: 10%, 12%, 22%, 24%, 32%, 35% and 37%. (Those are the rates for taxes due in April 2021.)
HERE’S THE THING THAT CONFUSES MOST PEOPLE: As you earn more and move up tax brackets, only the marginal amount—or the money in the higher tax bracket—is taxed at a higher rate, not the entire amount you earn.
Here’s an example. Let’s say Pat is a single filer who earns $100,000. Some of Pat’s 2020 income would hit the 24% tax bracket. But Pat would ONLY pay 24% tax on the part of his income that falls into that bracket, not on the entire $100,000.
In other words, Pat would pay 10% tax on the first $9875, 12% tax on the next chunk of his income between $9876 and $40,125, 22% tax on his income between $40,126 and $85,525, and 24% tax on the last piece of his income between $85,526 and $100,000. Otherwise put, Pat doesn’t pay 24% tax on $100,000, he pays something more like an average of 18.08% of tax on his income.
Many people are confused by marginal tax rates, believing the rate at which they will be taxed is a flat rate based on the income level into which they fall.
With that behind us, you’re set up to understand tax and alimony.
Old Tax Treatment for Alimony (Old Law)
Under the old law, alimony was tax-deductible to the person paying alimony, and taxable income to the person receiving alimony.
Generally speaking, a person paying alimony has a higher income — and therefore is in a higher marginal tax bracket — than a person receiving alimony.
For example, let’s say Pat has a former spouse, Sam, to whom Pat pays $5,000 of alimony a year. Sam makes $30,000 a year before alimony.
Based upon the sample brackets above, Sam would be taxed 12% on that alimony. But Sam gets a deduction at the 24% level.
At first blush, the old way seems good for the alimony payor Pat (who gets a tax deduction) and bad for the alimony recipient (who pays tax). But it’s more complicated than that.
But in many divorces — be they mediated, collaborative, or even litigated — the divorce agreement would “share” the benefit of the lower alimony tax bill so that both spouses receive financial upside of the lower tax bill.
New Tax Law on Alimony (New Law)
Under the 2017 tax law, alimony payments are no longer tax-deductible for the payer, and they aren’t considered taxable income for the recipient.
Does that mean no one pays tax any on alimony? No. Let’s go back to Pat and Sam and see how alimony taxation would work under the new law.
Sam works and pays income tax on a $100,000 salary. Under the old way, Pat would get to deduct the $5,000 of annual alimony paid to Sam. Under the new way, Pat pays income tax on salary but doesn’t get a deduction for alimony payments. Sam doesn’t pay any income on the $5000 in alimony Sam receives.
In other words, the government used to receive tax on the $5,000 paid at Pat’s lower, 12% tax bracket. Now, tax on the $12,000 is paid at Sam’s higher, 24% tax bracket.
Under the new system, the government gets paid more in taxes on alimony than it did under the old law.
Is Alimony Tax Deductible?
For some people, alimony is still tax-deductible. For others, it isn’t. It all depends on when your divorce happened.
Changes to the tax treatment of alimony under the 2017 tax law are effective on divorces or legal separations finalized after December 31, 2018.
So, if you were divorced prior to 2019, your alimony payments are probably still deductible.
But, if you were divorced after December 31, 2018, you probably cannot deduct alimony payments you make.
Do I Still Have to Pay Tax on Alimony?
If you were divorced prior to 2019, you probably still have to pay tax on alimony you receive.
However, if your divorce was final after December 31, 2018, you do not have to pay tax on alimony (because it was already paid by the payor).
How is Alimony Taxed if We Change Our Alimony Agreement After the Divorce?
What if Pat and Sam divorced in 2015, under the old rules. Pat gets a deduction for alimony paid and Sam pays income tax on alimony received. In 2021, Pat and Sam modified the amount of alimony Sam pays Pat. Does Pat still get a deduction and Sam still pay income tax on alimony?
Generally speaking, in pre-December 31, 2018 divorces, alimony is deductible from the income of the payer spouse and includable in the income of the receiving spouse, even if the agreement was modified after December 31, 2018.
The only exception is if the modification both:
- changes the terms of the alimony or separate maintenance payments; and
- states that the alimony or separate maintenance payments are not deductible by the payer spouse or includable in the income of the receiving spouse.
In other words, if Pat and Sam agree that they want the new tax treatment and specifically say so in the agreement they enter with the court, alimony will be treated the new way. Otherwise, the default is that they stick with the old way.
That was a lot — more? — than you ever thought you wanted to know about divorce, alimony, and taxes. But divorce has a tremendous impact on your finances for years to come. It’s important to understand how this works so that you can make informed decisions that move you toward the life you want to live.
Our first step at Freed Marcroft, the Goals & Planning Conference, is designed to get to the heart of your problem and unveil your true goals. Then, we take those goals along with the facts of your case and analyze them so that we can present you with recommendations and options on how to move forward.