Since 1942, a taxpayer who paid alimony or separate maintenance to a former spouse received an income tax deduction for the amount paid. The payor reported the amount paid as a favorable above-the-line deduction, where it was not subject to any limitations or phase-outs. The recipient of the alimony was then required to include the same amount in their own taxable income.
However, the TCJA put a rather surprising end to this long-standing treatment for alimony or separate maintenance payments. Under new rules, the payor will no longer receive a tax deduction and the recipient will no longer have taxable income. And unlike other TCJA provisions for individual taxpayers, which are only effective from 2018 through 2025, these new alimony rules are a permanent change.
What drove this change? Not surprisingly, alimony payors have been exceedingly reliable at claiming the tax deduction, but alimony recipients have not been nearly as reliable at reporting their corresponding amount of taxable income. Add to that fact the likelihood that the alimony payor is likely in a higher income tax bracket than the alimony recipient, and this change became a revenue raiser for a Congress in need of revenue raisers to offset rate cuts and other tax deductions.
The change applies to alimony or separate maintenance payments that are made pursuant to a divorce or separation agreement that is either:
- Executed after 12/31/18
- Executed on or before Dec. 31, 2018 but modified after that date, if the modification expressly provides that these amendments made by the Act will apply to that modified agreement.
Thus, the TCJA does provide a grandfather exception for payments that are made pursuant to a divorce or separation agreement that was already in effect before 1/1/19. For such agreements, the payor will still receive a tax deduction and the recipient will still have taxable income, unless the agreement is subsequently modified and the parties specifically agree to have the new rules of TCJA apply. This means that any modification to a pre-existing agreement may also reopen negotiations on whether the tax status of the prior agreement should be changed as well.
In addition to this change in the taxability of alimony payments on divorce agreements entered into after 2018, the TCJA may also change the economics of previously executed divorce agreements. Often, the terms of a divorce agreement are the result of carefully negotiation between the two parties, which should have included consideration of the tax impact of those terms on each party. One example of a negotiated provision that is impacted by the new tax law is the payment of a child’s education expenses.
If there are children involved, the divorce agreement may include a section addressing the payment of college expenses and the funding/use of a Sec. 529 plan to fund those college expenses. Since the TCJA now allows not only college expenses to paid out of a Sec. 529 plan, but also elementary and high school expenses, the cash balance of the Sec. 529 plan when the child begins college may be far less than anticipated at the time the agreement was signed. Since a pre-TCJA agreement would not have prohibited Sec. 529 plan funds from being used for pre-college expenses, the party required to fund college expenses may end up paying a greater amount out of their own pocket than expected during agreement negotiations.