In the event of divorce, a couple might spend a lot of time negotiating the terms of equitable distribution of their marital assets and spousal support. But college savings accounts, like 529 plans, often get overlooked during this process.
Most of the time, a child’s 529 plan is assumed to be the ‘child’s’ asset. The child is only a designated beneficiary.
Naturally, people probably think that a child’s education expenses are addressed by a state’s child support laws. And most state laws do address qualified education expenses until the age of 18.
However, because a 529 account is set up in a parent’s name, it’s actually a marital asset. Not accounting for this in a divorce might lead to unfortunate consequences down the road, even for the most well-intentioned families.
So to answer the question up front:
What happens to your child’s 529 plan account in a divorce largely depends on whether you actually address it during the divorce process.
This article outlines some of the divorce-specific details of 529 plan ownership, possible pitfalls and opportunities, and considerations for both divorcing parents to ensure the proper stewardship of their children’s 529 plans.
Background-Why Establish a 529 Plan In the First Place?
Usually, parents establish their child’s college savings plans in one of several ways:
- UTMA (Uniform Transfers to Minors Act) or UGMA (Uniform Gift to Minors Act)
- Coverdell Education Savings Accounts (known as Coverdell ESAs)
- 529 plans (formally known as a qualified tuition plan). 529 plans can be either a College Tuition Plan or a College Savings Account.
Nowadays, parents are more likely to establish a 529 plan than a Coverdell ESA or UTMA accounts for several reasons.
First, the tax benefits are better.
While contributions are made with after-tax dollars (for federal tax purposes), earnings in a 529 account accrue on a tax-deferred basis. Qualified distributions are not taxed. And thanks to the SECURE Act, there are more qualified expenses to put your money towards.
For example, you can use up to $10,000 (per person) to repay student loans. Also, 529 plans are no longer limited to college costs. You can use 529 plan funds to cover educational expenses at the K-12 grade level.
For residents who pay state income tax, many states offer a state income tax deduction for a plan owner who contributes to their home state’s 529 plan. Often, this coincides with lowering the costs of a child’s college education if they remain in the state.
Second, the parent retains control of the account.
Before 529 accounts, the most prevalent savings vehicles were UTMAs and UGMAs. Unfortunately, both of those accounts are technically ‘gifts’ to the child. Once money is deposited into one of those accounts, it’s considered a completed gift.
The only difference between the UTMA and a UGMA is the age at which the child takes ownership of the account. And once that ownership transfers, the child can do whatever they want with the money. That also includes not covering the cost of college.
But when parents set up a 529 account, they retain control of the money. So they can ensure that the money covers the costs of their child’s education.
Unfortunately, many parents usually don’t pay close attention to the ownership of that account. And that’s where things can go south in the event of a divorce.
Some states allow for joint ownership between married parents. However, some plans, like the Nevada Wealthfront 529 College Savings Plan, do not.
Even in cases where the plan allows for joint ownership, many applications are filled out by one (usually weary, sleep-deprived) parent.
So it’s easy to fill in one parent’s name on the application. Then the parents move on, assuming that the child actually owns the assets in that account.
And for parents who don’t get divorced, that’s usually not a problem. For divorcing parents, it could be a huge problem.
The biggest problem that can occur is that after the divorce, the account owner (in a non-joint ownership account) can do literally whatever they want. If there are nasty circumstances involved, this can be a very big problem for the other parent. Here are a couple of examples:
- Former spouse (account owner) pays for a private high school education. But the responsible parent wants to keep money available for college (or vice versa). Or graduate school.
- Account holder changes beneficiaries, against the wishes of the responsible parent.Non-custodial parent is the account owner. The noncustodial parent could marry into another family and make a step-child a new beneficiary.
- Account owner withdraws college funds from the 529 plan for non-college purposes. This is completely legal, as long as the owner accepts the tax consequences. This might include paying the associated tax and federal tax penalty on the non-qualified distribution.
- One parent is court-ordered to fund a 529 plan for the benefit of the child. Court order places the 529 plan in the responsible parent’s name. But the other parent has no obligations to spend the money on college.
While these possibilities might be identified by a proactive divorce attorney, or a discerning family court judge, there are many cases where 529 plans fall through the cracks.
On the flip side, there are several financial planning opportunities available to a divorcing couple who share a common vision for funding their children’s college educations. This is especially true when it comes to applying for federal student aid.
There are financial planning strategies that help account owners use 529 plan assets in a manner that minimizes impact on financial aid eligibility. So if financial aid is an important part of funding your children’s college education, here are some key points that matter:
- Who actually owns the account
- How disbursements are handled
- How the divorce documents are written. This includes the marital settlement agreement and the property settlement agreement.
There are plenty of financial planning opportunities when it comes to financial aid. But they can only work if both parents agree to terms that set the conditions to take advantage of them.
And financial aid is only part of the entire college planning picture. Which in turn is only part of the entire financial planning picture.
Many times, a divorce often occurs ten years (or longer) before minor children are even ready for college. So it’s important to allow for college planning in the divorce decree.
While you can’t nail down every possible contingency or regulatory change in advance, there are things you can do to set your children up for success. And one of those things is to ensure that your children’s 529 plans are properly addressed in your divorce agreement.
529 Plan Considerations For Your Divorce Agreement
While each divorce has unique circumstances, there are a couple of things you should do:
Hire a financial advisor who specializes in divorce.
Many financial planners offer traditional divorce planning services. But a financial planner’s true value is in keeping their eyes on your money:
- Where is the money?
- What could happen to the money?
- How do I protect myself against bad outcomes?
While your family law attorney is focused on your best interest, their advice usually is limited to legal advice, not financial advice. A financial planner can help you through the divorce, and often can help you with college planning afterwards as part of an ongoing service.
Talk with your attorney about your 529 plans
You want to make sure that all college savings assets are addressed as part of the divorce settlement.
Depending on the state you’re in, and how collaborative (or combative) your divorce might be, your lawyer might have different suggestions on how this gets done.
Your focus should be on ensuring that the divorce paperwork addresses them properly. Specifically, you’ll want to ensure that:
- Both parents have equal say in the distribution of assets. Even if one of them retains ownership of the account.
- The 529 plan(s) are properly accounted for as part of the equitable distribution. Along with all the other marital property.
- Future college contributions are taken into consideration. This will help ensure that one divorced parent isn’t spending the other’s money on non-qualified expenses.
- The documents clearly define which education uses are eligible and which are not. This is particularly important if the divorcing parents don’t agree on whether 529 funds should be used to fund K-12 or graduate education.
If your children are old enough, talk with them about their 529 accounts.
Many parents believe their children aren’t old enough to have a conversation about how to fund their college education. However, children of divorcing parents are going through a tumultuous time.
It’s important to have the conversation to let them each child that both parents still care for them. And that includes talking to them about money that their parents are saving for the child’s future. A kindergartener can understand the basic concepts, even if they might not understand all the details.
The divorce process can be a stressful one. It’s particularly stressful because it impacts so many other areas, like college planning.
But it’s important for divorcing couples to take the time to understand where all of their money is, and to safeguard against bad outcomes. Even the most well-intentioned families can stray off course over time. This is particularly true if the divorce paperwork doesn’t specifically address what can or cannot be done with a 529 plan.