How to Minimize Taxes in a Divorce Involving Spousal Maintenance

 Posted on May 14, 2019 in Illinois Divorce

For divorce settlements finalized on or after January 1, 2019, the tax treatment changed for spousal maintenance, aka alimony. This has had two effects on divorcing couples, one involving current-year income tax and the other affecting retirement savings.

Most divorce lawyers have focused on the income tax effect and how it makes the payment of spousal support less financially attractive to the payor. However, the revised tax law opens a new tax-savings opportunity related to the transfer of 401k and IRA accounts incident to divorce.

Paying maintenance via the transfer of tax-deferred retirement savings can offer multiple benefits. This approach can be especially beneficial for a maintenance recipient who has been a stay-at-home parent prior to divorce, particularly one over age 59½.

Pre-2019 Tax Rules on Maintenance Payments

Under the old tax rules, maintenance payments are deductible from the payor’s income and are taxable income for the recipient. Since the recipient is presumed to have a lower total income and lower tax rate, this tax treatment was beneficial to the couple as a whole. The payor paid less income tax, making the payment of spousal support somewhat less burdensome.

In addition, because maintenance payments were taxable income to the recipient, the recipient had the option to put some of that money into an IRA for retirement. If the recipient’s employer did not offer a 401k savings plan, the recipient could also take a tax deduction for IRA contributions.

Note that divorce settlements finalized before January 1, 2019, are still treated under these old tax rules. If a pre-2019 maintenance agreement is modified after January 1, 2019, maintenance will still be treated under the old tax rules unless the spouses specifically agree in writing to follow the new tax rules.

New 2019 Tax Rules on Maintenance Payments

Under the new tax rules, maintenance payments are taxable income for the payor and are tax-free for the recipient. Because the payor is now paying income tax on their total income, including maintenance payments, at their presumably higher tax rate, maintenance payments no longer offer any tax benefit to the payor. The payor effectively has less total funds available to make spousal and child support payments.

In addition, because maintenance payments are tax-free for the recipient, they do not count as earned income for the recipient. If the recipient has no earned income, they are not eligible to make tax-deductible IRA contributions.

401k and IRA Accounts Now Have a Higher Value in Divorce

In order for maintenance to be tax-deductible under the old tax rules, it had to be paid in cash. Now that maintenance is no longer a tax deduction for the payor, there is no tax benefit to paying monthly maintenance in cash. Thus, it makes sense to consider non-cash alternatives, that is, making a lump-sum transfer of assets as part of the divorce settlement in lieu of maintenance. This, of course, assumes that the couple has sufficient assets to make a lump-sum transfer feasible.

A transfer of funds held in an IRA or 401k plan offers tax advantages for both parties. At the same time, it provides future retirement benefits for the recipient spouse. These benefits mean that tax-deferred retirement accounts now have a higher value in divorce negotiations.

Benefits of Transferring a Tax-Deferred IRA or 401k in Lieu of Alimony

Making a lump-sum transfer of funds from the payor spouse’s tax-deferred IRA or 401k to an IRA in the recipient’s spouse name has several benefits:

• The payor never pays income tax on the transferred funds.

• The recipient pays no taxes when money is transferred into their IRA account.

• When the recipient reaches age 59½, they can withdraw the IRA funds and pay taxes at their presumably lower tax rate. In the meantime, the invested funds grow tax-free.

With this approach, both parties benefit by reducing the amount of money lost to taxes.

However, there are two possible downsides to consider.

First, if the recipient needs the funds to pay immediate expenses and is not yet age 59½, they will have to pay a 10% penalty on any withdrawals on top of the regular income taxes. In this case, consider transferring non-tax-deferred savings instead, such as a Roth IRA. As long as contributions to the Roth IRA began at last five years ago, withdrawals of original contributions can be made without penalty at any age. Earnings withdrawn prior to age 59½ will be subject only to regular income taxes.

The second possible downside is that the payor effectively reduces their own retirement savings. However, this may not be an issue in a high net worth divorce. The payor may be able to make catch-up payments to increase their tax-deferred retirement savings or simply pay for their retirement with non-tax-deferred savings.

Consult an Experienced Kane County Divorce Attorney

The financial decisions required in a divorce settlement, including the division of assets and the payment of spousal maintenance, can get very complicated. Consult an experienced St. Charles divorce lawyer for guidance. Call Weiler & Associates, Inc. at 630-331-9110.

Sources:

https://www.investmentnews.com/article/20180511/REG/180519980/divorce-2019-how-to-use-iras-and-401-k-s-to-ease-future-alimony

http://www.ilga.gov/legislation/ilcs/documents/075000050k504.htm