Benjamin Franklin was focused on future financial well-being when he wisely stated: “A penny saved is a penny earned.” In seeking an advantageous financial settlement in your divorce, knowing the differing tax consequences of different kinds of support payments will help you to better plan for your future financial well-being. As the payor, if you don’t understand the taxability of support payments, you may think you are being asked to pay more to your former spouse than you feel you can afford. As the recipient of support payments, you may be surprised to find that you owe money to the IRS when it comes time to file your taxes.
In a nut shell, child support, which is paid for the benefit of the child or children, is not considered income for tax purposes. Thus it is neither tax deductible to the payor nor taxable to the recipient. Sometimes it is said that child support is paid in “after-tax” dollars.
On the other hand, if it is structured correctly, alimony will be considered income for tax purposes, thus creating a tax deduction for the payor and a tax obligation for the recipient. In order to be considered alimony for federal tax purposes, several technical requirements must be met. For example, the alimony payments must be paid under court order or pursuant to a written separation agreement and must be paid in cash. The parties may not file a joint return for the applicable tax year and they may not be members of the same household. Further, amounts may not be disguised payments of child support or a property settlement. Experienced divorce counsel will ensure that both parties receive the bargain that they think they agreed to by meeting these requirements.
In addition to ensuring predictability and getting the benefit of the bargain, properly crafted alimony payments allow for the shifting of income from a higher tax bracket to a lower one, thus creating savings for the entire support-paying and receiving unit. For example, if the husband is in a 45% combined federal, state and local tax bracket while the wife is in a 25% combined bracket, then shifting income from the husband’s tax return to that of the wife would reduce the taxes on that income by the difference, or 20%.
In some cases, the two parties may wish to agree that support payments for the economically-dependent wife will neither be deductible to the payor nor taxable to the recipient. The parties may do so, as long as the tax treatment is reciprocal on the two sets of tax returns and further provided that the proper provisions are included in the written separation agreement. For example, if the Husband’s income is not taxed because he is employed by an international organization such as the World Bank or the IMF, then there would be no benefit to the tax shifting discussed above.
Optimally-beneficial tax planning is just one tool that an experienced divorce attorney can use in crafting your financial settlement. Whether you reside in DC, Maryland or Virginia and whether you are the payor or the recipient of support payments, a strategic use of the ins and outs of the tax code are essential to maximizing your financial future.