Take-Away: The 2017 Tax Act made a fundamental change in the income tax laws, effective January 1, 2019. It provides that there is no longer an income tax deduction for the payer of alimony or spousal support. As such, payments of alimony for judgments entered after that date will no longer be treated as taxable income to the recipient. But that also means the recipient will not be able to contribute those alimony funds received to an IRA, as was the case in the past.

Background: Under the prior tax law, a spousal support payer was able to claim an above-the-line income tax deduction for the amounts paid as alimony or spousal support. The recipient of the spousal support award was required to treat the alimony or spousal support received as taxable earned income.  This tax treatment was reversed effective January 1, 2019. Under the prior regime the Tax Code legally permitted the shift of taxable income to the lower earning former spouse, which often led to a lower overall income tax liability of the spousal support payments due to the lower income tax bracket of the recipient former spouse. With the 2017 Tax Act the new rules clearly favor the spousal support recipient, since the payments will no longer carry with them an income tax obligation, while they also create a significant income tax liability for a spousal support payer since the income earned is taxable, but then after-tax dollars will be used to pay the spousal support obligation.

  • Earned Income: Historically the spousal support payments received by a former spouse were considered to be earned income. Consequently, the recipient could contribute that earned income to a Roth IRA or traditional IRA. That is no longer the case
  • Loss of IRA Contributions: For the recipient of an alimony award under a divorce judgment or settlement agreement entered after January 1, 2019, the recipient will not be able to use the alimony award to fund a Roth IRA or traditional IRA. Obviously, if the recipient has other sources of earned income, that other earned income can still be used to fund a Roth IRA or traditional IRA (now $7,000 a year if over age 50 years.)

Trust as Alimony Alternative: It may be possible to use an irrevocable, non-grantor trust as an option if the goal is to shift taxable income to a former spouse. However, that income will not be treated as earned income for purposes of a former spouse’s contribution to an IRA or Roth IRA. Key to this planning strategy is to wait until after the divorce is final and the individuals are no longer married. Then transfer assets to the irrevocable non-grantor trust. The former spouse would be named as the income beneficiary of that trust. As the trust assets generate income, that income will be distributed to the former spouse-beneficiary. Each distribution from the trust will carry out distributable net income (DNI) which will be taxable to the former spouse-beneficiary, with the shift of income tax liability akin to the ‘old’ alimony rules where the recipient had to report the distribution as taxable income, while the payer of the alimony was entitled to an income tax deduction. If the assets were transferred to the trust while the individuals were still married, then the trust would be classified as a grantor trust for income tax purposes, and the trust’s settlor (the former spouse) would be taxed on all of the trust’s income; that is why the trust cannot be funded until after the divorce is final and the marriage no longer persists. The transfer of assets to the irrevocable trust should be gift-tax free because the transfer would be incident to a divorce and thus gift tax-free. [IRC 2516.] Admittedly, however, there is another trap posed by IRC 2702 if the couple’s children are named as remainder beneficiaries of the non-grantor trust; again, waiting until after the individuals are no longer married, so that the income beneficiary is not an applicable family member related to the settlor will avoid the implications of IRC 2702.

Conclusion: While this change in the income tax law will help former spouses become financially re-established in the short term, since the spousal support amounts that is received will not be eroded by income taxes, by the same token it will be that much more difficult for the former spouse to plan for his/her own retirement if the spousal support that they receive can no longer be used to fund their own retirement IRA. You may also recall the 2018 Bankruptcy Court Panel decision, Brian A. Lerbakken (Bankruptcy 8th Cir, No. 186018) which held that a former spouse who received a portion of their spouse’s traditional IRA and 401(k) account incident to a divorce settlement lost those assets in a subsequent bankruptcy proceeding, where those retirement accounts were not treated as creditor-exempt retirement accounts, since the bankrupt former spouse had not contributed his own funds to the IRA and 401(k) account. This tax law change and the bankruptcy court’s decision to not protect an IRA received in a divorce settlement will make it more difficult for a former spouse to be self-sufficient in their retirement years, which is where a trust established for a former spouse might shift taxable income and yet protect the transferred assets from the former spouse beneficiary’s creditors assuming the trust contains a spendthrift clause.