Daily Deduction: Alimony Payments


When we think of divorce, we think of alimony.  It is the traditional support payment that one spouse makes to another under a court order.  Although on the surface it’s a burden to the spouse who pays and a benefit to the one who receives, in tax terms it is exactly the opposite.  That’s because a spouse who makes alimony payments can deduct them for federal tax purposes.  A spouse who receives them must pay taxes on them, just as if they were wages. 

The tax treatment of alimony can be especially helpful for couples in certain circumstances.  For instance, the alimony deduction can move a higher-earning spouse into a lower tax bracket.  This, of course, shifts some of the tax burden onto the lower-earning spouse, who will then have more income and be taxed at a higher rate.  The divorced couple will save money overall, and they can negotiate a settlement that will allow them to share the savings.  For instance, if the alimony deduction helps one spouse save $1,200, she can split it with her ex.  He’ll get an extra $50 each month, and she’ll still come out $600 ahead at tax time. 

To take advantage of the deduction, you must make your alimony payment by cash or check.  You cannot, for instance, pay your spouse in shoes, apple pies, or real estate.  You can make payments on her behalf though.  A mortgage payment made on behalf of your ex can qualify as alimony, and so can payments to your life insurance company if your ex is the beneficiary of your policy.  You can even pay your ex-spouse’s credit card bill and claim the alimony deduction.  As usual, there is one additional catch: The payment must be ordered by a court in a separation or divorce decree.

Of course, not every person who pays alimony wants to claim the deduction, and not every person who receives it is willing to claim it as income.  As a result, a couple can opt out of the usual treatment of alimony.  In that case, the spouse who pays cannot deduct, and the spouse who receives isn’t required to pay tax on the money received.  When might a couple opt out?  If the receiving spouse is at the high end of her tax bracket, treating alimony payments as taxable income might push her into the next bracket and increase the couple’s taxes overall.

Whether you want to take the traditional route—where the paying spouse deducts and the receiving spouse includes the payment in his income—or accept the alternative approach, you will need to estimate your taxable income and your spouse’s as well.  If you are at the low end of a tax bracket, making an alimony payment may actually save you money.  But if your spouse is at the high end of a tax bracket, receiving an alimony payment may actually cost him money.  Knowing which result is the most likely to occur will help not just you, but everyone at the bargaining table.

Finally, if you or your ex stop making alimony payments within three years, the IRS may take some of your deductions back.  It goes without saying, then, that every alimony agreement should last for at least three years. 

So we’ve covered the cash, but what about the house, the car and the retirement plans?  Transfers of property between divorcing spouses are usually tax free.  This is true even if the property is transferred in exchange for cash or in return for the release of marital rights in other property.  There is one restriction though. The transfer must be related to the end of your marriage.  To be on the safe side, you should make sure the court includes all of your property transfers in your divorce decree.  This provides the IRS with conclusive proof that you should not be taxed on the transfer.  And you’re not limited to the Prius (Stock Quote: TM) and your wife’s favorite sofa.  The no-tax rule also applies to health savings accounts, Archer medical savings accounts, individual retirement accounts (IRAs) and virtually any other kind of transferrable interest in property. 

Be sure to check out the complete archive of Daily Deductions.

Related Stories:
Annulment vs. Divorce: The Financial Differences

Five Ways to Reduce the Cost of a Divorce

What Happens to 529 Plans After Divorce?

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