Tip of the Month:
Alimony & Divorce: Tax Benefit or Tax Trap

There are many times when alimony (taxable spousal support) should not be used in a divorce settlement because it may increase joint taxes even when the parties are in different tax brackets. Alimony can actually increase the joint taxes of the divorcing individuals in divorces where the lower paid custodial parent is eligible for the Earned Income Credit.

What Kind of Nonsense Is This
The typical response to this Tax Tip might be that it must be wrong. We all know that when the divorcing individuals are in different tax brackets, alimony has historically been used to create tax savings between the parties and alimony is considered to be a very powerful planning tool in the tool chest of the family lawyer. Many of you have purchased software primarily to fine tune the alimony decisions common to many divorce cases. If you use FinPlan’s Divorce Planner® software, you will never get caught in this quicksand because FinPlan is the only divorce software program available which will instantly let you know you are making a mistake with a poorly planned alimony scenario like the one to be described in this article

For those of you who do not use financial planning software for divorce, the rest of this Tax Tip will illustrate how you could easily make a serious error in your calculations and what to look for in future “alimony cases”.

Problem
The basic problem is that a simple analysis of alimony based on different tax rates is not adequate because the alimony will also impact the Earned Income Credit of the party receiving alimony. The Earned Income Credit (EIC) continues to grow each year as inflation adjustments ripple through the tax rates and this credit for 2004 will apply to individuals making up to $34,500 with 2 or more children (lower EIC for 1 child). The maximum EIC for a family with 2 or more children is $4,300 for 2004 so we are talking about some significant dollars for a lower earning custodial parent in a divorce.

What the simple analysis will miss is that the joint tax savings to the couple from being in different tax brackets can be reduced or even eliminated because the alimony will reduce the potential Earned Income Credit. Alimony increases the custodial parent’s Adjusted Gross Income which will reduce the EIC otherwise allowed based on the person’s earnings. The problem exists in the middle income divorce which warrants some spousal support but not a huge amount. In a long term marriage where the parties have a significant disparity of income and alimony will be a significant element of the divorce settlement, this problem will not be apparent. Once the custodial parent’s Adjusted Gross Income exceeds $34,500 including the alimony, then the tax bracket percentage differences will be able to create the favorable financial impact generally associated with alimony.

The only way the typical family attorney will catch this is to use good divorce tax planning software or a financial professional. Since the cases where this is a problem are middle income cases with smaller potential alimony levels, financial professionals are generally not going to be involved due to cost considerations. So the practical options for the family lawyer are a good software program like FinPlan or to never use alimony in any case where the total income of the receiving spouse after alimony is less than $35,000. You are not going to make any serious error if you follow this general rule but you may be missing opportunities unless you start to use good divorce planning software. If you are still caught in the old time methodology of just looking at your client and ignoring the financial implications of both parties, you need to alter your approach. The truly effective family lawyer understands that the minimization of joint taxes in a divorce is the best approach to optimize the settlement for their client (either husband or wife). Lower taxes mean more settlement dollars to share and getting your client a better share of a larger pot is a good objective.

Illustration
The following example is for those who want to better understand how the numbers work in the middle income divorce case with potential alimony.

Case Facts

When these case facts are entered into FinPlan’s software program the following results are shown:

Case 1 Guideline Child Support

Assume that this case would be an alimony case in your state. Mother has about $39,000 to pay the bills for herself and the 2 children while father has almost $43,000 for himself. If there were budgets (cash expenses) prepared for this case, father would have more cash than his budget and mother would not have enough cash to pay the expenses for her family including the children.

Case 2 Guideline Child Support plus $10,000 of Alimony
If $10,000 of alimony is integrated into this case, the numbers for taxes and after-tax cash are going to change as shown below:

The total after-tax cash has actually decreased by about $1,000 from $82,688 to $81,696. Normally with these individuals having a 10% tax bracket differential, you might expect the $10,000 of alimony to create an extra $1,000 of cash from reduced taxes. These tax bracket savings actually do take place but they are offset by elimination of the Earned Income Credit of almost $2,000. Alimony actually increases the joint tax of the parties and alimony should not be used in a case like this.

A superficial analysis will just look at the mother and see that she has more cash with alimony than she had without it and leave it at that.

Case 3 No Alimony - Increase Guideline Child Support by $7,000
The right way to get more dollars to mother in these kinds of situations is to either increase guideline child support or use non-taxable spousal support. If instead of the alimony, you increased the guideline child support by $7,000 then the after-tax cash position of the parties would be as shown below:

Each party has more after-tax cash in case 3 than in case 2 and mother retains the $2,000 Earned Income Credit.

A really effective family lawyer understands how taxes impact divorce settlements so mistakes like the one illustrated above can be averted. The days of family lawyers ignoring taxes because this is “not part of the job” are limited. Good software to assist family lawyers has been available for many years and the malpractice issues are not going to go away. Ignorance is not bliss – it costs divorcing clients a lot of money.