The growing divorce rate in America has led to the creation of various
types of spousal support where one ex-spouse is required to pay to the
other. In most cases, the higher-earning spouse is required to pay the
lower earner a certain amount, although there are exceptions to this.
However, the tax rules are not the same for all types of support -
some types are reportable as income while others are not. That said,
the rules for each kind of support are relatively simple to learn.
This article explores the factors that determine how spousal support
is classified and subsequently taxed.
*Tutorial: Financial Concepts*
Types of Spousal Support
There are two main types of support that are awarded to ex-spouses
today. One is known as alimony and the other is called child support.
The former type of support has become relatively less common over time
and has largely been replaced with child support for divorcing couples
with children. Both types of support are awarded by either a divorce
decree, written agreement of separation or decree of support. Failure
to pay either one of them can result in further legal action,
including garnishment of tax refunds of the payor or additional
litigation by the rightful recipient. Different regions typically have
different laws that outline the consequences of nonpayment.
*Alimony*
This type of spousal support is often awarded in divorces where
children are not involved. In most cases, alimony payments are tax
deductible by the payor and reportable as taxable income by the
recipient. However, the following requirements must be met to receive
this tax treatment:
* Alimony must be clearly specified in the divorce, annulment or
separation agreement. No payments that are made under any
circumstances outside this agreement can be labeled as such.
* Alimony must be specified as a mandatory payment in the agreement.
Any voluntary payments that are made to one ex-spouse by the other
cannot be considered alimony and are not deductible or taxable for
the payor or receiver respectively.
* Alimony payments must be made in cash, or through such liquid
payments as checks and money orders. All transfers of noncash
property fall outside this category.
* Deductions of aggregate alimony payments of more than $15,000 that
are made in the first or second year may be recaptured in the
second or third year if a lesser payment is made that year. (The
rules pertaining to this provision are somewhat complicated and
those to whom they apply should seek counsel from their tax or
financial advisor.)
* Any provision that payments made to an ex-spouse for the purpose
of supporting children or dependents automatically disqualifies
the payments as alimony.
* Payments made by one ex-spouse to another cannot be considered
alimony if both spouses still live in the same household when the
payments are made.
* Alimony payments cannot last beyond the death of the paying
spouse. If payments are continued into the recipients active
accounts, none of the payments can be deducted for tax purposes.
* Alimony can also be nondeductible and therefore nontaxable if both
spouses agree to specify this in the divorce decree.
Alimony paid is reportable as an above-the-line deduction, which
means that the payor is not required to itemize in order to deduct
these payments. Taxpayers who pay alimony must include the Social
Security number(s) of any and all ex-spouses to whom payments are
made in order to deduct the payments. Failure to do so will result
in disallowance of the deduction. Those receiving payments must
provide their Social Security numbers to the paying spouse or face a
penalty from the IRS.
*Child Support*
This form of spousal support is specifically designated to be for the
benefit of any children that are supported by the ex-spouse receiving
the payments. Child support is never deductible by the payor and is
not reportable or taxable as income by the recipient. Any type of
monetary payment made by one ex-spouse to another that either ceases,
diminishes or otherwise changes upon the occurrence of certain events
pertaining to the children, such as their reaching the age of majority
or moving out of the house, results in a modification to child support
requirements. As mentioned previously, both the IRS and state
governments have the authority to garnish any tax refunds due to
delinquent payors of child support.
*Property Settlements and QDROs*
Any initial division of property that is made because of a divorce is
usually considered a tax-free exchange of property by the IRS. The
recipient takes on the basis of any property received and pays no
income tax upon its transfer. Any type of IRA or retirement plan that
is transferred from one spouse to another under a qualified domestic
relations order (QDRO) is also considered a tax-free exchange of
property.
*Which Type of Payment is Better?*
As you can see, alimony payments obviously favor the payor, while
child support payments are more beneficial to the recipient from a tax
perspective. However, there are several factors that divorcing couples
should consider when determining the nature and amount of payments
that are to be made. Of course, the issue of who will get to claim the
dependency exemptions and tax credits for any children involved as
dependents is another key issue. If one spouse's income is too high
to be able to claim any potential tax benefits benefits, then it may
be wise to allow the other spouse to do so, perhaps in return for
receiving taxable alimony payments instead of child support. If the
receiving spouse's income is fairly low, then receiving alimony
payments may have little or no impact upon his or her income, and
therefore may be elected in return for other benefits to be provided
by the payor, such as a more favorable custody agreement. The nature
of the payment requirements also depend on the overall circumstances
of the divorce.
*Bottom Line*Of course, the good will of both ex-spouses is necessary
to logically determine what arrangement is best for both parties;
therefore, divorcing couples should recognize that it is in both
parties' best interests to know these rules and plan accordingly.
Failure to understand the tax implications of divorce can often lead
to missed credits and deductions that ultimately reduce the income of
both parties involved. Couples who are contemplating divorce or who
have begun the divorce process may be wise to consult a professional
with specialized training in the financial ramifications of divorce,
such as a certified divorce specialist.
*by Mark P. Cussen*,CFP®, CMFC
Mark P. Cussen has more than 15 years of experience in the financial
industry, which includes working with investments, insurance,
mortgages, taxes and financial planning. He has two years of
experience in writing and editing insurance and securities test
training manuals, as well as other financial topics. He has also
worked in retail, discount and bank brokerage systems and been
involved in a venture capital enterprise in the oil and gas sector.
Cussen has a Bachelor of Science in English from the University of
Kansas and completed his CFP coursework at the Bloch School of
Business at the University of Missouri-Kansas City in August of 2001.
Source: Investopedia.Com
