The tax impact of alimony, child support, unallocated support
When navigating through divorce, three key terms will appear regularly — alimony (also known as spousal support or maintenance), child support, and unallocated support (also known as family support or separate maintenance). It is important to know what these terms mean, why they exist, their tax implications, and how they will affect your divorce settlement for many years.
Alimony is a court ordered series of payments from the higher earning spouse in the marriage. These payments help the lower earning spouse ease into life post-divorce with financial help, although if both parties are employed there may not be a need for alimony. The amount of alimony is a subjective decision and can be negotiated between parties. Ultimately though, at an impasse, a judge could set alimony based on factors such as the length of the marriage, the economic variance of one spouse to the other, their ages, and their behavior in court. Alimony payments are tax deductible to the spouse paying them and taxable income to the recipient. Alimony may or may not be modified over time depending on the settlement arrangement.
Child support is also court ordered, although unlike alimony, it is not negotiable, except upwards. Strict statutes based on the “net income” of the non-custodial parent, number of children, health insurance costs and other variables determine these payments. They are not tax deductible payments to the spouse paying them, nor considered taxable income to the spouse receiving them and are always subject to modification.
Unallocated support (“family support or separate maintenance”) allows the combination of alimony and child support to create a payment that becomes a tax deduction to the payor and taxable income to the payee. This has long been used as a “win-win” strategy to settle support issues in contested divorce cases, when settlement seems remote.
The key here is moving money (in the form of increased support) from the payor (-in a higher tax-bracket) to the payee (-in a lower tax-bracket). It is the difference between the tax brackets of the spouses where the savings are found and divided between them. Shifting the tax bracket moves money to the payee and taxes it at their lower tax rate. This tax savings is shared and allows support to be set in a way where the payor doesn’t mind paying more than they otherwise would, because, after taking the tax deduction, they pay less than had the alimony and child support been treated as separate payments. Likewise, the recipient of support doesn’t mind paying taxes on the unallocated support because even after paying taxes, they receive more money than had they been receiving alimony and child support separately. Both spouses have more disposable income after taxes.
Unallocated support won’t work for every case though. It might not work in a settlement when both spouses make about the same income. In that case, there is no benefit by shifting tax-brackets. It won’t work when one spouse doesn’t earn much now, but will work when it’s anticipated that he or she will earn as much as the other spouse in coming months. Finally, when setting the unallocated amount it is important that both spouses benefit (as opposed to only the higher income spouse benefiting from the tax treatment) or else it doesn’t work either.
Because unallocated support combines alimony and child support payments, the child support portion always means the entire unallocated support payment is modifiable. For individuals with substantial incomes, tax benefits aside, there is more certainty involved in making separate alimony and child support payments because alimony can be negotiated as non-modifiable. This is important for individuals who foresee increased earnings, or who do not want to leave themselves open to a review and possible increase of alimony payments during the term of their settlement.
Understanding the differences between alimony, child support, unallocated support, and their tax implications are just the starting point in structuring a divorce settlement or a separation agreement. Having a competent financial team in place can pay dividends in years to come as your divorce settlement plays out. Feel free to call me or email me with any questions you may have. 312.578.2678.
Graham Craig, Financial Advisor and Certified Divorce Financial Analyst™ (CDFA™)
Email: firstname.lastname@example.org Website: www.bairdfinancialadvisor.com/gbcraig