Since tax rates are many times different for the parties getting divorced, there is the potential to significantly increase the value of a part of the property settlement by paying the property as alimony. While a bird in the hand is generally better than two in the bush, there will be times when this technique makes sense. Overall tax savings may be significant - the value of a lump sum property settlement may be increased by 16-18%. The question is when does the technique work. Answer is that one party must be in 33% or higher tax bracket and the other in the 15% or 25% and how to share the tax savings.
The Lump Sum menu will show if this will work and the Present Value of Alimony Payments menu will show how to allocate the tax savings.
At times you will be asked to evaluate whether monthly payments in lieu of a lump sum should be taxable (alimony) or nontaxable (property). Under the lump sum option you may determine if this is economic.
Enter the following:
Annual interest rate for discounting (generally, a tax free rate is suggested),
The marginal federal and state tax rates of the individuals,
The lump sum alimony amount, and
The number of monthly payments being considered.
Note: Changes in tax brackets are not considered in this calculation and thus, the overall result should be treated as a reasonable approximation. The annual interest rate for discounting should be a municipal bond rate and not an interest rate on which taxes would be paid on the interest.
Federal and state tax rates are available through the menu. Note that for higher income individuals (33% & 35% brackets) the marginal tax rate should be increased if itemized deductions are being phased out (.7%) and if personal exemptions are still being phased out (about .6% for each exemption).
Marginal tax rates are used in this analysis, since the evaluation is focused on alimony and alimony is not a required item in a divorce. It is the last item to be analyzed and marginal tax rates are appropriate for this analysis.
If you use the full Divorce Planner program, you may enter the overall marginal tax rate from the Divorce Planner output reports and leave the state tax rate at zero. The software assumes that itemized deductions are taken and thus state taxes are a deduction for federal taxes (i.e., taxes payable on alimony received or the alimony deduction taken for alimony paid reflect a lower federal rate to the extent of the deductibility of state taxes).
The software calculates an overall marginal tax rate as:
Formula: State % + (Federal % - (Federal % * State %))
Calculate the report. The results will appear as the Monthly Alimony Payment reflecting taxes. The monthly property (nontaxable) amount is also shown for evaluating a property settlement paid as a monthly amount including interest. This analysis shows the range of possible alimony payments which reduce total taxes. The Present Value of Alimony Payments menu is used to determine how to split these tax savings.
The appropriate interest (discount) rate to be used in this analysis is the tax free municipal rate for the time period being analyzed.
Note: Do not use an interest rate that is taxable, but instead use a rate that has no taxes associated with it.
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