Monday, October 17, 2005

Is alimony always tax deductible to the person who pays it?

Generally, alimony is tax deductible to the person who pays it and this can result in a significant tax savings for the payor (person who pays alimony) as well as a tax bill for the payee (person who receives the alimony). This means that if you pay alimony - you may get anincome tax deduction. If you receive alimony, you may owe income taxes.

Just because you call it alimony, does not mean that the Internal Revenue Service will agree. In fact, the Internal Revenue Code defines "alimony" or "separate maintenance payments." In Pennsylvania and New Jersey, common terms also include spousal support, alimony pendente lite and maintenance. No matter what the payment is called, the analysis must be performed under the statute.

The statute requires that the payment must be in cash. This is important because some spouses make arrangements, early in the separation, for one of the spouses to directly pay bills for the other, such as mortgage and household bills. Because one spouse is not paying cash to the other spouse, these payments would probably not be considered alimony.

The payment must be "received by.... a spouse under a divorce or separation instrument." This means that there must be some type of writing that qualifies as a divorce or separation instrument. This could include a court order, a written separation agreement or a property settlement agreement. In the instrument, the amount of the payment should be specified, as well as the frequency of the payment and language stating that the payment is for the support of the spouse, as opposed to for the support of any children of the relationship.

The divorce or separation instrument must exclude language that states that the payment is not includible in gross income or not deductible to the payee spouse. To be considered alimony, the spouses may not be members of the same household at the time that the payment is made.
The liability to make the payments must cease at the death of the payee spouse and there must not be an arrangement to continue any payments or substitute payments after death of the payee spouse.

The tax savings from deducting alimony payments can provide an economic boost to the payor spouse at a time when resources are stretched. Separation and divorce usually involves taking the same amount of income that supported one intact family to fund to separate households. Tax deductibility of the payments is a way to stretch the income. An accountant can assist the payor spouse with adjusting the withholding tax from the paychecks so that less tax is withheld from each paycheck and therefore more cash is available for immediate spending.

When there are minor children involved, any support order usually contains two components: support for the spouse and support for the children. Support of children versus spouses is treated differently for tax purposes. Child support is not taxable to the Payee or deductible to the Payor. Recently, the United States Court of Appeals for the Third Circuit was faced with a case where the court order did not specify which portion of the support order was for child support and which portion was for spousal support. This is known as an unallocated order. In Patricia Kean v. Commissioner of Internal Revenue, Wife received varying amounts of support from Husband pursuant to court orders. The language of the court orders stated that the support was for the purpose of maintaining Wife, the children and the household. However, there was no other language that specifically apportioned the payments between Wife and children. Ultimately, even though a portion of these payments were intended for the support of the children, the court considered the entire sum to be alimony, and therefore taxable to Wife. In this particular case, Wife ended up owing a significant amount in taxes.

As this case demonstrates, tax consequences should be considered with regard to any support order as taxes owed (or taxes deducted) can have significant financial consequences. An accountant can analyze the tax effects.

Sunday, October 09, 2005

How are Retirement Plans Divided in Divorce?

For many divorcing couples, the two largest assets are the equity in the marital home and the retirement plans that the couple have accumulated. Accordingly, these are the two main assets to be divided in the event of divorce.

Retirement plans take on many different forms and three types are listed below:

1. Individual Retirement Accounts (IRAs) - usually an account at a bank or other financial institution that a party contributes to each year;

2. 401k plans - a plan administered by an employer that an employee contributes to out of each paycheck;

3. Pension Plans - generally, a set amount awarded to an employee at retirement age, usually paid monthly. These types of plans, known also as "defined benefit plans" are being offered less and less by employers. Most private sector employers are phasing out this type of plan.

If, as part of the distribution of the assets, the parties decide to divide a retirement plan, a Qualified Domestic Relations Order is usually required, called QDRO for short (pronounced "Quadro "). What is a Qualified Domestic Relations Order? A qualified domestic relation order is a domestic relations order (court order) that creates or recognizes the existence of another person’s right to receive, or assigns to another person the right to receive, all or a portion of the benefits in a retirement plan. By law, a QDRO must include certain information and meet certain requirements.

Generally speaking, a party cannot touch their retirement benefits until they are of retirement age, without incurring current taxes and penalties. A QDRO divides the retirement benefits at the source and places a portion (or all of the assets) in another person’s name without incurring the tax liability or penalties, even if the parties are no where near retirement age.
In some marriages, only one individual is contributing to a retirement plan. The other spouse may not be working or may not be earning enough to contribute to a plan. Sometimes, for cash flow reasons, only one party contributes to a retirement plan while the other pays certain bills or expenses. Upon separation or divorce, a QDRO provides the mechanism to divide this asset, without incurring current taxes or penalties.

Divorcing persons deciding on a distribution of assets must prioritize retirement planning. A qualified financial planner or accountant can assist with setting goals. If division of a retirement plan is part of the distribution of assets, anticipate the need for a QDRO and discuss it with your attorney as part of the overall strategy in divorce.