The Tax Cut and Jobs Act (TCJA) that went into effect this year for divorcing couples has drastically changed the financial landscape for individuals from prior years. The most significant change is that spousal support (alimony) is no longer deductible if paid or taxable income if received. Many states, including Colorado, have updated spousal support guidelines to take into consideration these modifications. Overall, these changes have effectively reduced financial resources for both spouses because Uncle Sam is receiving a larger slice of the pie. Although this repeal has been a headline story in the media, what other financial issues have been affected and are there any new planning strategies to help navigate the new terrain?
Most notably, the individual paying spousal support will have a significantly higher tax burden. Therefore, their ability to claim other tax deductions such as medical deductions (taxpayers can deduct medical expenses that exceed 10% of their AGI) or any tax incentives available that are linked to income have also been affected. Eligibility to participate in a Roth IRA may also be more difficult to qualify for since contributions are only available to taxpayers with an AGI of $122,000 or less in 2019. Higher income earners may also find themselves paying the 3.8% Medicare surtax that is levied upon single taxpayers with incomes above $200,000 whereas married couples filing jointly weren’t subject to this tax until their income was above $250,000.
According to the Pew Research Center, ‘Grey Divorces’ for those over the age of 50, have doubled over the past 25 years. This combined with the recent tax overhaul has made saving for retirement significantly more challenging during a period of time where most couples are trying to make the most of their last minute savings efforts.
Most spousal support recipient’s over the age of 50 have spent the past 20+ years tending to family at home, relying on their spouse's income to build their nest egg, and now depend solely on spousal support for the majority of their income. These spouses, with no earned income, are not eligible to contribute to an individual retirement account (previously spousal support was considered pass through ‘earned income’ and was eligible to contribute to individual retirement accounts). Therefore, the ability to save for retirement during the last leg of the race before retirement has been significantly hindered if additional employment is not obtained or considered during divorce proceedings.
A stark difference between taxable and non-taxable spousal support has completely changed the financial landscape for many divorcees. Change can be challenging however, when we are able to re-frame change we can also find opportunity. This year while working with divorcees it has been my goal to uncover just that - what are the opportunities in this new environment? The following are some examples of what has surfaced for spousal support recipients:
*Spouses with extremely low taxable income will be able to deduct a larger portion of their medical expenses that are over 10% of their AGI.
*Individuals working part-time earning less then $15,570 this year while receiving support will qualify for the Earned Income Tax Credit that wouldn't have been available in prior years.
Creating Tax-Free Retirement Income:
Retirement planning opportunities may exist especially for the Grey Divorcee's who can take advantage of the vast difference in taxable income before and after retirement. The following graph shows the significant difference for a 55-year-old receiving $50,000/yr in tax-free spousal support plus earning $20,000/yr through employment versus at age 67 years when spousal support ends and nearly all income sources are completely taxable:
Based on the above example, 72% of the income prior to retirement is tax-free with only $20,000 being taxable income whereas, nearly all the income after the age of 67 is taxable (Social Security is 85% taxable). The difference in tax liability would increase approximately 5.5 times due to this disparity assuming the individual is claiming the standard deduction.
Extending Tax-Free Spousal Support into Retirement
The situation above can provide an opportunity to utilize low income tax strategies for several years while spousal support is being paid. Annual Roth IRA Conversions can take advantage of these income differences effectively extending the life of retirement assets. The following example shows how this strategy works prior to age 67:
Scenario 1: shows the growth of a $200,000 IRA account growing at 7% per year with no additional contributions from 55 to 67 years old. At the age of 67, $420,970 is available in a fully taxable IRA account. All withdrawals from a traditional IRA account will be 100% taxable income (shown as red in the above chart) which usually increases the amount of withdrawal a taxpayer needs in order to pay the necessary taxes associated unless other readily available assets are available outside the IRA.
Scenario 2: is an example of utilizing an Annual Roth Conversion strategy to transfer retirement assets from a fully taxable IRA account to a tax-free Roth account, assuming the same 7% growth rate for both accounts. On an annual basis, $22,000 is transferred from the IRA to the Roth IRA and taxable at 12%. Over the course of a 12-year period the taxpayer pays $37,380 in taxes associated with the conversions. By the age of 67, the balance in the fully taxable traditional IRA is almost zero and the bulk of retirement savings, $417,852, are in the Roth IRA account where all future growth and distributions are tax-free (shown as green in the above chart).
It should be noted that because distributions from the Roth account are tax-free, the necessary required withdrawals are smaller because no tax liability is created with the withdrawal. Therefore, the Roth IRA will retain its principal, continuing to grow during retirement at a much more robust level providing significant additional financial resources to retirees over their lifetime compared to the IRA account.
Just as the stock market landscape changes from year-to-year (or day-to-day recently!) the overall financial landscape for divorcing couples has dramatically changed, especially for those over the age of 50. As we navigate the new terrain, opportunities to build wealth in any circumstance are still available with proactive planning. Working with a Certified Divorce Financial Analyst (CDFA) and Certified Financial Planner™ while settling a divorce can strengthen post-divorce financial recovery.
You wouldn’t retire without a financial plan… it might be messy!
Don’t divorce without one either!
Disclosure: Divorce transition/financial planning