Divorce can derail college savings

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.

Custodial parent

Only one parent is required to file the Free Application for Federal Student Aid (FAFSA). This parent is called the custodial parent and the other biological/adoptive parent the noncustodial parent.

Normally, the custodial parent is the parent with whom the student lived the most during the 12 months ending on the date the FAFSA is filed. Since there are an odd number of days in the year, the living arrangements are usually definitive. However, there are some circumstances during which there might be an even number of days, such as during a recent divorce or a leap year.

If the student lived equally with both parents, then the custodial parent is the parent who provided the most support.

Generally, the student will qualify for more financial aid if the custodial parent is the parent with the lower income. To the extent that the parents can control which parent is considered the custodial parent, it may be beneficial to consider the impact on financial aid eligibility.

However, if the custodial 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 expected family contribution (EFC) and decreases the student’s eligibility for need-based financial aid.

But, there are potential cross-currents that can increase eligibility for need-based financial aid. If the stepparent has children from a previous marriage and provides more than half their support, the children are counted in household size even if they don’t live with the stepparent. If some of these children are enrolled in college on at least a half-time basis, they are also counted in the number of children in college. The parent contribution is divided by the number of children in college, which can have a big impact on aid eligibility.

529 plans owned by the noncustodial parent

529 college savings plans that are owned by the custodial parent are reported as parent assets on the FAFSAs filed by the custodial parent’s children. Distributions from such 529 plans are ignored. 

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 FAFSAs filed by the custodial parent’s children. Distributions from these 529 plans are ignored.

However, any 529 plans that are owned by the noncustodial parent are not reported as assets and any distributions count as untaxed income to the beneficiary. This is the same treatment as for grandparent-owned 529 plans. The noncustodial parent is not considered a parent for federal student aid purposes.

This can have a big impact on eligibility for need-based financial aid. Parent assets reduce aid eligibility by at most 5.64% of the asset value. If a 529 plan is not reported as an asset on the FAFSA, distributions count as untaxed income to the student, reducing aid eligibility by as much as half of the distribution amount. Thus, $10,000 as a parent asset reduces aid by up to $564, while $10,000 as a noncustodial parent asset reduces aid by as much as $5,000.

There are a few potential workarounds: 

• The parents can change the 529 plan account ownership as part of the divorce decree, so that the custodial parent is the account owner. All state 529 plans allow the account owner to be changed in the event of divorce. 
• The noncustodial parent can wait until after January 1 of the sophomore year in college to take a distribution to pay the student’s college costs, assuming that the student will graduate in four years and will not immediately enroll in graduate school. Since the FAFSA bases income on the prior prior year, there will be no subsequent FAFSA to be affected by the untaxed income. (If the student will need five years to graduate, distributions from the 529 plan that is owned by the noncustodial parent should wait until after January 1 of the junior year in college.
• The noncustodial parent can roll over one year’s funds to a 529 plan that is owned by the custodial parent after the FAFSA is filed. Because of the timing, the funds do not get reported as an asset on the FAFSA, yet the distributions are still ignored as income. Note that the custodial parent’s 529 plan must be in the same state as the noncustodial parent’s 529 plan to avoid recapture rules. Some states will recapture state income tax benefits if the 529 plan is rolled over to another state’s 529 plan.

Gifts from the noncustodial parent to the student

Since the noncustodial parent is not considered a parent for federal student aid purposes, gifts from the noncustodial parent to the student count as untaxed income to the student if they are outside the requirements of a child support agreement. Gifts from the noncustodial parent to the custodial parent, however, are ignored. 

Non-qualified 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 custodial parent gets remarried, the custodial 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 custodial parent and stepparent get divorced, the 529 plan accounts might be considered marital assets, subject to division as part of the divorce decree.