Alimony or child support? A big tax difference

f you are divorced and have young children, there’s a good chance that you are paying or receiving alimony or child support (or both) under a divorce decree. What’s the difference? The distinction is important to the IRS.

Currently, alimony is deductible by the party who pays it and taxable to the party who receives it. Child support is neither deductible nor taxable.

Depending on what side of the fence you’re on, you should negotiate for payments to be characterized as either “alimony” or “child support” as part of a divorce agreement.

How to qualify for alimony deductions

Just saying that payments are alimony won’t suffice. According to the IRS, these are the requirements that must be met if you’re hoping to qualify for alimony deductions:

  • You don’t file a joint return with your ex-spouse
  • Payments are made in cash or an equivalent
  • Payments follow the instructions of a divorce or separation agreement
  • The agreement doesn’t designate the payment as not being alimony
  • You and your spouse aren’t members of the same household when the payment is made
  • There’s no liability for making the payment after your spouse dies

The following alimony payments aren’t considered deductible:

  • Non-cash property settlements in a lump-sum or installments
  • Payments that are a spouse’s part of community property income
  • Payments to keep up the property owned by the person paying alimony
  • Use of the property owned by the person paying alimony
  • Voluntary payments

The terms can often be worked out to the satisfaction of both parties. For instance, the deduction for alimony can be valuable to someone who pays alimony and earns more while the taxable income may not cause any dire consequences to someone who earns less.

According to the new tax bill, alimony will not be deductible or taxable starting in 2019. This may also affect divorce and separation agreements executed in 2018 and modified in 2019 and beyond.

Keep these rules in mind when your 2017 tax return is filed. The staff at Dye & Whitcomb can help you determine tax issues related to your alimony payments.

Tapping your retirement account early?

Consider these factors:

Ideally, you should try not to tap your 401(k) or IRA accounts before it’s time to retire. But life happens. In certain situations, you may need to withdraw a portion of your nest egg while you’re still working full time. Here are three scenarios where this may be the case — and possible alternatives to avoid tapping your retirement accounts too soon:

You’re drowning in high-interest debt. Your retirement plan may allow for a 401(k) loan that can be used to pay off expensive credit card accounts. Although the loan is paid back to your own account (paying yourself the interest), this solution has some disadvantages. For one thing, money that’s withdrawn from your 401(k) account isn’t available for long-term growth. Also, should you lose your job, the loan may become due immediately.

If you can’t settle the debt right away, you may be subject to a 10 percent early withdrawal penalty and regular income taxes on the outstanding loan balance. Consider paying off debts using other funding sources as it may be a more prudent solution.

You’re facing foreclosure on your home. The hit to your credit score can be devastating if you default on a mortgage. But, again, using your retirement nest egg should be considered a last resort. You may be better off working with your lender to revamp your mortgage. Consider extending the term or renegotiating the interest rate to reduce monthly payments.

You’re heading back to college. If you need to retool for a new career, the IRS allows you to make penalty-free withdrawals from your IRA accounts before age 59½ if the money is applied toward higher education expenses. But be aware that the same rules do not apply to 401(k) accounts. If you haven’t reached age 59½ and use funds from a 401(k) to cover college expenses, early withdrawal penalties and income taxes may apply.

The best way to avoid penalties is to understand the rules around retirement account withdrawals. Give us a call to learn more about tax penalties you may face if you withdraw funds early from retirement accounts. We can help you create the best plan for your situation.

Should you hire your spouse?

Maybe your spouse helps out at your small corporation without pay. Although wages are taxable and fringe benefits cost your company, you could be missing out on tax-saving opportunities for hiring your spouse. Consider the following:

  • You’re saving money in the company 401(k), but what about your spouse? If certain requirements are met, your spouse can contribute to the plan while the business deducts contributions made on his or her behalf. Frequently, your spouse can build a tidy nest egg within the tax law’s contribution limits.
  • If you’re paying a hefty bill for your spouse’s health insurance coverage, hiring your spouse as an employee will likely save money.The amount of your company’s payment is deductible by the business — just like it is for any other employee — even if you’re self-employed.
  • You typically can’t deduct your spouse’s travel expenses like you can for yourself if he or she is accompanying you on a business trip.However, if there’s a legitimate business reason for your spouse to make the trip, the travel expenses — such as airfare, hotels and 50 percent of the cost of meals — become deductible.
  • Is your spouse planning to attend school to improve business skills?If he or she enrolls in courses through an educational assistance plan, the cost is generally deductible by your business. For the employee-spouse, annual benefits of up to $5,250 are exempt from tax.
  • Does your business provide group-term life insurance coverage on a nondiscriminatory basis? Then you know the cost is deductible by the business and the first $50,000 of coverage is tax-free to employees. As a bona fide employee, your spouse can be covered under the plan.

There’s one catch: S corporation owners generally can’t deduct fringe benefits for any employee owning 2 percent or more of the company. This prohibition extends to coverage for an owner’s spouse. Your tax advisor can help you determine when it makes sense to put your spouse on the payroll.

Lending money to a relative? Avoid a tax trap

Suppose a relative wants to borrow money for a business venture or to buy a home. It’s true that family loans can raise problems. But if you’re going to do it, take the tax law into account. Otherwise, you could have an unexpected problem on your hands.

Here’s what to watch out for

It all has to do with “imputed interest” rules that may apply if you don’t charge the going rate of interest on the loan. Essentially, the IRS treats the loan as if interest were required, even if you’re not charging any interest, or you’re imposing an unusually low rate. Thus, the interest is “imputed” to you — the lender — based on IRS figures.

In other words, the IRS treats it like you’ve received taxable interest from the relative, even though you may not be getting a penny. Thus, you could be facing a tax bill that you probably weren’t counting on.

Fortunately, the tax law provides two exceptions to these “imputed interest” rules:

  • If you lend your relative less than $10,000, you have no tax worries, unless the money is used to purchase income-producing property. You can charge no interest (or an extremely low interest rate) without any tax repercussions.
  • If the money is a gift, you also don’t have to deal with interest. You and your spouse can each give up to $14,000 ($15,000 in 2018) to an individual each year.

There are additional complexities for some family loans, but those are the main tax rules to address. If possible, stay below the thresholds for either of the two exceptions. Alternatively, charge an interest rate and use a formal loan document resembling one found at a bank. Your professional advisors can help you with the details.