Even an amicable divorce can cause problems with a child’s college savings plans. Divorce attorneys are not financial aid experts. They may not be aware of all of the potential consequences of divorce on a child’s eligibility for financial aid or the nuances of need-analysis formulas.
Generally, the custodial parent should also be the account owner of the child’s 529 college savings plans.
Division of marital assets
It is difficult to predict how a court might treat a 529 college savings plan during the division of marital assets. Some courts treat the 529 plan as funds set aside for the benefit of the child and exclude it from the division of marital assets. Other courts might require the account owner to pay half of the value of the 529 plan to the other parent. After all, a 529 college savings plan is considered an asset of the account owner, even if it is intended to be used to pay for the college costs of the beneficiary. The account owner can change the beneficiary or even take a non-qualified distribution.
College support
If the divorce decree provides for college support, qualified distributions from a 529 plan might not count as part of that parent’s contribution toward college costs, even if the 529 plan was started after the divorce was final. 529 plans might count as a child asset, since it is considered a completed gift. Some courts, however, will consider a distribution from a 529 plan to be a contribution from the account owner.
Financial Aid considerations
Which parent files the FAFSA
If the parents are divorced or separated, and living apart, only one parent is required to file the Free Application for Federal Student Aid (FAFSA). This parent is the one who provides greater financial support to the child, regardless of which parent the child lives with more.
If both parents provided equal financial support, then the parent who earns more will file.
If the FAFSA-filing parent has remarried as of the date the FAFSA is filed, the income and assets of the stepparent must be reported, regardless of any prenuptial agreements. This usually increases the Student Aid Index (SAI) and decreases the student’s eligibility for need-based financial aid.
A 529 plan owned by this parent will be reported as a parent asset on the FAFSA.
529 plans owned by the parents
529 college savings plans that are owned by the parent who is filing the FAFSA are reported as a parent asset. Distributions from such 529 plans will also not be reported as untaxed student income on the FAFSA.
If the custodial parent has remarried as of the date the FAFSA is filed, any 529 plans owned by the stepparent are also reported as parent assets on the FAFSA filed by the filing parent’s children. Distributions from these 529 plans are ignored.
However, any 529 plans that are owned by the parent not filing the FAFSA are not reported as assets. Distributions are also not counted as untaxed income to the beneficiary. This parent is not considered a parent for federal student aid purposes.
Parent assets reduce aid eligibility by at most 5.64% of the asset value, so they have a minimal impact on financial aid. However, 5.64% is still greater than zero. Therefore keeping the 529 plan ownership with the parent who provides less financial support may be advantageous.
If desired, the parents can change the 529 plan account ownership as part of the divorce decree, so that the parent who provides less financial support is the account owner. All state 529 plans allow the account owner to be changed in the event of divorce.
Gifts from parent to student
Under new rules that go into effect with the 2024-2025 FAFSA, cash support and money paid by the non-FAFSA filing parent on the student’s behalf will not count as untaxed income to the student. This can have a huge positive impact on financial aid eligibility, since as much as 50% of student income is counted on the FAFSA as available funds for college.
Non-qualified 529 plan distributions
The owner of a 529 college savings plan can choose to make non-qualified distributions from the 529 plan. Nothing prevents this parent from draining the 529 plan account.
If one parent does not trust the other parent to behave responsibly, it may be best to transfer ownership of the account or to take other steps to preserve the assets for the child’s education. This could include adding restrictions on how the 529 plan funds may be used as part of the divorce decree. The parent who is not the account owner should also be provided with “interested party” statements from the 529 plan account.
Prenuptial agreements
If the parent who owns the 529 plan gets remarried, the parent and stepparent should sign a prenuptial agreement to specify that the existing 529 plans remain assets of their respective owners, to preserve the assets for their beneficiaries.
Otherwise, if the parent and stepparent get divorced, the 529 plan accounts might be considered marital assets, subject to division as part of the divorce decree.
