The Tax Implications of Divorce: Alimony, Child Support, IRAs and More

Divorce is a complex and emotionally charged process that also brings substantial financial considerations, with three of the most significant financial aspects of a divorce being alimony (spousal support), child support, and property division under Internal Revenue Code (“Code”)[1] Section 1041. Understanding the tax implications of these decisions is critical, as they can significantly impact the financial stability of both spouses after divorce. In addition, there are other important considerations in structuring divorce settlement negotiations — such as when spouses must begin filing separately, how the Internal Revenue Service (“IRS”) treats prior-year taxes, and handling transfers to and from individual retirement accounts (“IRAs”).

Alimony and Child Support

The Tax Cuts and Jobs Act (“TCJA”)[2], signed into law in 2017 and largely effective beginning in 2018, brought about wide-ranging changes to the Code. In particular, the TCJA had an impact in the way alimony is treated for tax purposes, while child support remained largely unaffected.

Before the TCJA, alimony payments were tax deductible for the payor and taxable income for the recipient.[3] This provided a tax benefit to the payor but created a tax liability for the recipient, aligning the tax burden with the end recipient of the income. But since 2019, alimony payments are no longer deductible for the payor or taxable for the recipient. This change could have a significant impact on the tax liability of both spouses and could substantially alter the financial dynamics of a divorce. For instance, the spouse paying alimony may negotiate for a lower amount because the payments are no longer deductible, or the recipient spouse may bargain for a greater share of other marital assets to make up for the loss of income. Likewise, child support payments are treated similarly to spousal support (i.e., not deductible by the payor and not taxable income for the recipient), so the same considerations apply.[4] Therefore, it is essential to consult a tax professional to understand the tax ramifications of divorce settlement options.

Tax Filings

For many couples, a significant issue arises when deciding how to file taxes post-divorce. The IRS allows married couples to file jointly while still married, but once a divorce is finalized, they must file as “single” or “head of household” (if they qualify).[5] Put another way, agreeing to file jointly while a divorce is pending or strategically delaying the finalization of a divorce can lead to substantial tax savings for the higher earning spouse.

Divorce settlements often address the allocation between the spouses of tax liabilities or tax refunds from prior years. While the IRS is unlikely to interfere with how a divorcing couple agrees to divide a refund, if one spouse agrees to pay for taxes owed from a prior year but fails to do so, the IRS will pursue the other spouse for any unpaid tax debt. In that event, that spouse may need to consider whether innocent spouse relief or other forms of relief from joint liability are available.

Division of Assets

The division of assets in a divorce is often a contentious issue. Under Code Section 1041[6], property transfers between spouses incident to divorce are generally tax free. This helps to facilitate the division of assets without triggering capital gains or other taxable income at the time of the transfer. When property is transferred under Code Section 1041, the receiving spouse inherits the original tax basis (or purchase price, sometimes adjusted for depreciation or other deductions) of the property. If the property is later sold, taxable gain will be based on the original tax basis and not the fair market value at the time of the transfer. In certain cases, therefore, it may be worth bargaining to keep the higher basis assets during property division.

In certain circumstances, however, property division can be taxable. For example, if property transfers occur over several years and appear to be alimony, they can be recast as alimony. However, if alimony decreases or ends in the first 3 calendar years, it is possible for the alimony to be recast as a division of assets. Additionally, if the transfers are made to a nonresident ex-spouse, there may be income or gift tax implications of the transfer.

IRA Transfers

Transferring assets from IRAs as part of a divorce settlement is another key concern, as these accounts can contain significant amounts of retirement savings. Generally, transfers of IRAs between spouses as part of a divorce settlement are tax free.[7] These transfers are allowed under a divorce decree or separation agreement. Withdrawing funds from an IRA before age 59½ usually results not only in taxable income, but also in a 10% penalty.[8] If an IRA balance is transferred directly from one spouse’s account to another (without being withdrawn by the original account holder), however, early withdrawal penalties can be avoided.

Conclusion

Divorce involves complex financial decisions that can have lasting tax consequences. By understanding the tax treatment of alimony, child support, property division, and IRA transfers, individuals can better navigate the financial landscape of divorce settlements. In addition, understanding the timing of tax filings and the ramifications of past joint tax liabilities, as well as utilizing expert advice during negotiations, can help the prepared spouse negotiate a more financially stable post-divorce future. Individuals going through a divorce should consult with a tax professional who can provide guidance specific to their situation.

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[1] All references to Sections in this article are to sections of the Code, unless otherwise stated.

[2] Tax Cuts and Jobs Act: A comparison for businesses | Internal Revenue Service

[3] Topic no. 452, Alimony and separate maintenance | Internal Revenue Service

[4] Tax Laws and Child Support | Child Custody and Support Law Center | Justia

[5] Filing taxes after divorce or separation | Internal Revenue Service

[6] 26 U.S. Code § 1041 – Transfers of property between spouses or incident to divorce | U.S. Code | US Law | LII / Legal Information Institute

[7] Publication 504 (2024), Divorced or Separated Individuals | Internal Revenue Service

[8] Retirement plans FAQs regarding IRAs distributions (withdrawals) | Internal Revenue Service