Alimony payments offer a less taxing alternative

Reduced payments have consequences

The complications don't end there. If alimony payments in any year are reduced by $15,000 in the first three calendar years after separation or divorce, part or all of such payments will not be considered deductible and the past payments may be "recaptured." In other words, the government would reclassify that money as income and tax you in arrears. Not a pretty sight. The reason for this law is because the IRS is trying to differentiate between ongoing alimony payments and any one-time, or short-term settlements that arise after divorces, such as the selling of properties or other valuables.

Under current law, the tax burden on property settlements has shifted from the payers to the recipients. The spouse who receives the property is then taxed when she or he sells it.

Shifting income

Several tax-planning strategies present themselves based on the above rules. The bottom line is alimony is deductible and child support is not. If the recipient is in a lower tax bracket than the payer, any increase in alimony from child support will be taxed at a lower marginal rate and deducted at the payer's higher marginal rate. This strategy gives both ex-spouses the chance to save or get more money, because of the way the government defines alimony and child support for tax purposes. It's a little tricky, but quite legal.

For example, assume the husband is paying the alimony. He has a marginal tax bracket of 33%, while his wife's marginal tax bracket is 15%. The husband plans to pay annual alimony of $10,000 and child support of another $10,000, and the wife has agreed.

This agreement would cost the husband $16,700 per year, based on the following formula:

• Child support: (no deduction): $10,000

• Alimony: $10,000 minus $3,300 tax savings ($10,000 x .33): $6,700

• Total: $16,700

If the husband converted the whole $20,000 to alimony, it would cost him only $13,400:

• Alimony: $20,000 minus $6,600 tax savings (or $20,000 x .33): $13,400

He saves $3,400 over the original agreement.

But this deal isn't fair to the wife. She would now have:

• Alimony: $20,000 minus $3,000 tax (or $20,000 x .15): $17,000

That's a loss of $1,500 for the wife when compared with the $10,000/$10,000 split.

But if both spouses can't get past the emotions to the bottom line, there is a compromise that helps both. The wife's loss could be offset by the $3,300 saved by the husband. All he would have to do is increase the alimony payments to $22,500. Here's how it works:

• Cost to husband: ($22,500 x .33): $15,075

• Wife: ($22,500 x .15): $19,125

The result equals an additional $1,175 in the husband's pocket ($16,700 vs. $15,525) and an additional $625 for the wife ($19,125 - $18,500)

Everybody wins except the IRS!

This concept of shifting income from a high-bracket taxpayer (husband) to a lower-bracket taxpayer (wife) works with property settlements as well. If a husband transfers stock that has appreciated from $10,000 to $100,000 to his wife, current law relieves him of the tax on the gain and shifts it to his wife when she sells.

To offset this tax, the recipient spouse should negotiate an increased payout to absorb, or reduce, the other spouse's net tax savings on the transfer of appreciated property.

Remember, while any marital dissolution is painful, both emotionally and financially, a recognition of the tax aspects of such a dissolution might minimize some of that pain.

Jeff Schnepper is the author of the best-selling "How to Pay Zero Taxes," which is in its 15th edition. He has written several other books on finance and taxation including "TurboTax Deluxe," "How Much is it Worth? Asset and Business Valuation," "The New Bankruptcy Law: A Professional Handbook," and "Inside the IRS, How it Works (You Over)." A former professor of taxation, accounting and finance, Schnepper has argued before the U.S. Supreme Court and has appeared on numerous national and local television programs. He lives in New Jersey.

Updated May 26, 2009

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