April 1, 2014
An often overlooked area in divorce negotiations is 529 college savings accounts. Because they are earmarked for college it is easy to think that there is nothing to discuss. However the divorce decree should address how these funds are to be invested, monitored and paid out.
529s are tax-deferred savings accounts –earnings are not taxed as they accrue and distributions are tax-free if they are used to pay for qualified higher education expenses. The account has an owner, typically a parent, while the student is the account beneficiary. Usually one parent is the account owner but a 529 can have joint ownership. If one parent is distrustful of the other, and is concerned that he or she might withdraw the funds in the account, then joint ownership would be recommended. An alternative strategy would be to split the 529 into two accounts, giving each spouse ownership of half the funds. A non-owner spouse can also be set up to receive interested-party statements as a way to keep an eye on the account.
Spouses should discuss who to name as the successor owner of the account, the person who takes over if the owner dies. If it is not going to be the remaining living parent then you will want to know it is someone who is financially capable, and has the student’s best interest at heart.
Each 529 plan offers a selection of investments that the account owner can choose from to create a portfolio with a desired allocation of stocks, bonds or cash (all usually in the form of mutual funds.) Financial planners typically advise parents to lean more heavily toward bonds as the student approaches college age as a way to protect the money that has built up in the account. This can be done by changing the allocation periodically, but an easier way is to choose the “age-based” allocation that most funds offer. This selection creates a portfolio with a percentage in stocks that is risk-adjusted annually as the child gets older until it is primarily bonds when the child reaches 18. How the account is invested - what percentage to put in stocks – and how that should change as the child approaches college-age is something that should be discussed and put in writing.
Funds withdrawn from the 529 plan are tax-free if used to pay for college expenses. Care needs to be taken not to withdraw more than what is allowed. Qualified expenses (including tuition, room and board and other expenses as outlined in IRS Publication 970) are reduced by the amount of expenses applied to the Lifelong Learning Credit or the American Opportunity tax credit as well as any grants and scholarships the student receives. The earnings portion of any withdrawal over and above qualified expenses is subject to income tax and a 10% penalty.
The divorce decree should note when withdrawals are allowed and for what purposes, to help prevent an irresponsible spouse from making withdrawals for their own intent. Both spouses should be aware of, and approve, any withdrawals that result in penalties or taxes.
What happens if the child doesn’t go to college, or doesn’t need all the money in the 529 plan? Unless there is another sibling, parent or cousin who can use the money for college, the funds will have to be withdrawn for a non-qualified purpose. Both spouses should agree on how to split those taxes (while the IRS will look to the account owner for payment, the non-owner spouse could reimburse half the taxes.)
Just as with other co-parenting issues, it is advisable to outline in the divorce decree the maintenance and use of a 529 plan to ensure that the money so carefully saved will be there when it is needed.
