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Tax Considerations

Terms:


Effective Tax Rate:
The ratio, generally expressed in percentages, of taxes paid to a taxpayer’s total income.  For individual income taxes, the effective tax rate is typically expressed as the ratio of taxes to adjusted gross income.


How the distribution is classified, determines its taxability.  Specifically, property settlements are not taxable transactions to either spouse.  See IRC § 1041.  Alimony used to be taxable to the recipient and deductible by the payor provided it met certain requirements.  See IRC §§ 71 and 215, respectively. However, under the 2017 Tax Cuts and Jobs Act, alimony and separate maintenance payments under a divorce or separation agreement executed after 2018 are not deductible by the payor. Those amounts are also not includable in the income of the recipient.    

EXAMPLE: Walter and Karen divorced in 2016.  In their divorce decree, Karen was awarded $15,000 per year in alimony and a lump sum payment of $50,000.  Only the alimony payments meet all the IRS requirements to be deductible.  Since Walter can deduct these payments, he can reduce his taxable income by $15,000 per year.  If his effective tax rate is 28%, this deduction would save him $4,200 in taxes.

A payment to, or for, a spouse under a divorce or separate instrument, is alimony if the spouses do not file a joint return with each other and all the following requirements are met:

  • The payment is in cash.
  • The instrument does not designate the payment as "not alimony".
  • The spouses are not members of the same household at the time the payments are made.  This requirement applies only if the spouses are legally separated under a decree of divorce or separate maintenance.
  • There is no liability to make any payment (in cash or property) after the death of the recipient spouse.
  • The payment is not treated as child support.

To get the benefit of a deduction, the amounts attributable to alimony must be designated as such in a written divorce decree.  One reason the Internal Revenue Service requires specific designation is so that the payor does not overstate the deductible amounts paid to the ex-spouse. Not all payments under a divorce or separation instrument are alimony.

Alimony does not include:

  • Child support,
  • Noncash property settlements,
  • Payments that are the spouse’s part of community income,
  • Payments to keep up the payer’s property, or
  • Use of property.

Any amounts that do not meet the alimony definition are neither deductible nor includable in income. The biggest area for possible abuse clearly is child support.

This is just an overview of the tax considerations involved in divorce. More detailed discussion of this subject is beyond the scope of this topic.