Couples entering a Massachusetts divorce often address issues in their separation agreements relating to college savings accounts.
Here are two important questions to consider if you and your spouse are going through a divorce:
Where is the money saved?
- 529 savings plans - Assets held in a 529 plan are considered a completed gift and held outside the taxable estate of the account owner, which can be a double-edged sword. The flexibility that makes a 529 savings plan so appealing could allow a vindictive spouse financial leverage over the beneficiary. For example, there's nothing to stop an ex-wife or husband from changing the beneficiary of record and withdrawing assets to pay for their own (or someone else's) higher education expenses, sitting on the funds, or simply revoking the account. This is why it is so important that, regardless of who is listed as the account owner, to specify in the separation agreement that the funds are to only be used for the interest of the beneficiary.
- Coverdell Education Savings Accounts (ESAs) - For purposes of a divorce, Coverdell ESAs are treated the same as 529 accounts, with the assets being outside the estate of the account owner. The account owner can change the beneficiary to another family member, including potentially to themselves. Unlike 529s, the account must be paid to the beneficiary within 30 days following the beneficiary turning 30, potentially incurring penalties and tax consequences. Further, the IRS specifically calls out transfers due to divorce. Any Coverdell received as part of a divorce is not treated as a taxable event, and the subsequent owner treats the Coverdell as if they were the original owner.
- Custodial 529 and UGMA/UTMA accounts - Custodial accounts are one of the best ways to ensure that money intended for a specific child are used for that child. Unlike 529 plans and Coverdell ESAs, the beneficiary of a custodial account can never be changed. Assets deposited are considered a completed gift to the child, and are outside the estate of the custodian of record. However, the beneficiary either takes ownership or has the right to take ownership once they reach the age of majority.
What should be included in the agreement?
- Qualified withdrawals - There are some gray areas concerning qualified higher education expenses and divorce law. For example, what happens if the student lives with one parent and pays rent using assets from the 529 account? This can be an excellent use of funds, as it helps defray some of the living expenses, but the arrangement must be fair and transparent between the former spouses. A 529 plan account owner can also withdraw funds penalty-free in the event the beneficiary becomes disabled, passes away, receives a scholarship, veteran's educational assistance, or other nontaxable education payment that isn't a gift or inheritance.
- Non-qualified withdrawals - There are situations in which non-qualified withdrawals are warranted. In an emergency or times of financial stress, such as a divorce, it may make more sense to draw down on college savings rather than tapping retirement funds, depending on the financial situation of the partners. In this case the account owner must pay taxes on earnings plus a 10% penalty. If there are no earnings, there is no penalty, since contributions to a 529 plan are made with after-tax dollars. Just know that the account owner has control of the assets, and that while contributions are treated as a completed gift to the child from a tax perspective, the account owner can technically revoke the gift, close out the account, and pay the taxes and penalties.
- State tax benefits - Many states offer residents a tax incentive for contributions to a 529 plan. While a tax deduction is not an asset itself, it may warrant opening a second account so that both parties can take advantage.
- Successor owners - You need to be clear in who is listed as the successor in the event of the death of the owner of a 529 plan, or any savings account. If a former spouse were to remarry and then pass away, you'd want to make sure any accounts that had your children listed as beneficiary remain in their best interest. If the account were to pass to the new spouse via probate because a successor was not listed, the new account owner could change the beneficiary listed on the account.
- Statements - If the account benefits your children, you should know what's going on. If you can't be a joint account holder, be sure to specify that you want to be listed as an interested party so you will receive duplicate statements.
When it comes to your child's savings, there are many options available in the course of divorce proceedings, including establishing a trust, dividing assets in a 529 plan into two accounts within the same program and/or modifying your 529 plan to a custodial account.
Should you be in the midst of a divorce or contemplating divorce, contact the Law Offices of Renee Lazar either through email or telephone 978-844-4095 to schedule a FREE one hour no obligation consultation to discuss issues related to college expenses.