As the tax advantages of alimony payments have disappeared for divorces occurring in 2019 and beyond, tax-deferred retirement savings (i.e., traditional IRAs) may provide divorcing couples an alternative planning opportunity.
The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the tax deduction for alimony for divorce agreements executed after December 31, 2018. Under the old law, these spousal payments were deductible to the person paying alimony and taxable to the alimony recipient. Under the new law, the individual who pays alimony to an ex-spouse will no longer be able to deduct those payments, and the recipient will no longer pay taxes on that income. Existing (pre-2019) divorce agreements will not be affected by the new rules, nor will modifications of pre-2019 agreements unless explicitly modified to adopt this provision in 2019.
As these changes to the tax treatment of alimony favor the recipient, a strategy using pretax retirement savings in lieu of alimony payments offers a potential win for the spouse paying as well. The following paragraphs explain this strategy.
The spouse who is required to pay alimony transfers a portion of his/her pretax retirement savings account (i.e., tradtional IRA) through a property division agreement or qualified domestic relations order (QDRO), thereby satisfying his/her obligation to the recipient spouse. But, because the account is funded with pretax dollars, the spouse required to pay will not have to pay tax on the amount transferred to the recipient spouse, or any future withdrawal of those funds, effectively gaining a tax advantage.
The recipient spouse receives a pretax retirement savings account (i.e., traditional IRA) tax-free because property settlements are not taxable. He/She can continue to contribute to this traditional IRA up to the annual contribution limits provided he/she has earned income, and will pay ordinary income tax on the earnings when withdrawn.
There are some caveats to substituting retirement savings for conventional alimony. Recipient spouses younger than age 59½ may need cash to pay for living expenses, and withdrawals from these retirement accounts could be subject to the 10% early withdrawal penalty. The spouse required to pay also will lose the benefits of having tax-deferred retirement savings with regard to the transferred amount. In addition, retirement assets acquired during a divorce may be available to bankruptcy creditors, as decided in Brian A. Lerbakken, Debtor-Appellant v. Sieloff and Associaties, but this issue is far from settled in all jurisdictions.
|Strategy||Spouse Required to Pay||Spouse Receiving Payment|
|Using asset subject to ordinary income tax in favor of other assets||
Consider your clients ages 59½ or thereabouts who may be facing a divorce. Tax-deferred retirement savings can provide these divorcing couples an alternative planning opportunity under the new law, provided the conditions are just right.
If you have any questions regarding alimony and the new tax law, please feel free to contact the Pacific Life Retirement Strategies Group at (800) 722-2333, ext. 3939, or send an email to RSG@PacificLife.com.
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