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529 Plans in Divorce: Worth a Second Look

By Kristen Shearin on June 27, 2016

When considering the financial aspects of a divorce, every asset is worth a second look. In many cases, the parties have 529 plans for their children’s college education. In most mediated settlements, the parties put the 529 plan in the children’s column and there is little discussion over which parent will manage the account. Most clients are not familiar with the rules and regulations that govern 529 plans.

Depending on your client’s financial situation, a 529 account can be a valuable asset. Obviously, most parents want their children to have the opportunity to attend college. However, the reality is 529 accounts are marital funds and the parties may need those funds now for a variety of reasons. A child may qualify for a student loan at a later date, but your client can’t get a loan for their rent, food, or healthcare coverage. If your clients are forced to put their living expenses on credit cards due to their separation and divorce, they may get themselves into a debt situation in which they can’t provide for the children’s basic needs – let alone college. Student loans typically have an interest rate of 7 to 8 percent while most credit cards have an interest rate of 12 to 24 percent. The reality is that 529 plans contain marital funds, and the parties may need these funds for a variety of reasons.

The funds in a 529 plan can only be used without penalty for certain qualifying expenses such as tuition. If you take a nonqualified distribution, the earnings portion of that distribution will be taxed as ordinary income and could incur a 10 percent federal tax penalty. However, the penalty may be waived if there are extenuating circumstances, such as the disability or death of the beneficiary, or if the child receives a scholarship, veterans’ education assistance, or other nontaxable education payment that is not a gift or inheritance. Also keep in mind that the state income tax, in many states, may be due on the amount you withdraw, and your state may impose an additional 10 percent penalty on earnings for nonqualified withdrawals.

Essentially, a 10 percent penalty is not that bad. We all have clients who choose to incur a penalty to cash out their IRAs. According to Amy Dieffenbach, CPA, you contribute to a 529 on an after-tax basis, so only the earnings from the 529 are taxable upon withdrawal (if not used for educational purposes), not the principal. If the 529 has earned money, your client incurs a 10 percent penalty on any earnings you withdraw (if not for educational purposes), and the earnings you withdraw will also be taxed as ordinary income at both the federal and state level. If you received a state tax deduction for your contributions, you may be required to pay taxes on the deductions as well, but only at the state level. If your 529 plan has lost money and you cash out the plan entirely, the IRS allows you to claim the loss as an itemized deduction. Basically, the custodian of the account has the ability to cash out the 529 plan for a penalty that is less than the interest rates on most credit cards. Are you writing language into your agreement that covers this possibility?

Here’s another thing to consider. In my state of North Carolina, residents who contribute to a North Carolina 529 plan receive a state income tax deduction of up to $2,500 per contributor. This means that even if a North Carolina resident contributes more than $2,500 on behalf of multiple children, they are still only allowed to deduct a maximum of $2,500 on their return. Only one divorced spouse is permitted to be the custodian of the account. Is this tax deduction important to your client? Which parties have the ability and/or plan to continue to contribute to the plan? Did you even ask?

Most separation agreements require that the funds in a 529 plan be used for the children’s education, but what happens if the money is not used for the child’s education for one reason or another? Don’t forget, we learned above that if your child gets a scholarship, the 10 percent penalty is waived so an ex-spouse who is custodian of the account could withdraw the funds without penalty and potentially keep the funds without consequence. The spouse in charge of the account also has the option to change the designated beneficiary to another member of the original beneficiary’s family. Under this provision, your client’s 529 plan which was meant for the benefit of the children could be used by an ex-spouse for one of their other children or step-children. Does the language in your agreement prevent this?

If your client takes money out of a 529 account for anything other than a qualifying expense, they will incur penalties. However, if they are in need of money now, it might be worth talking to an accountant to determine the exact penalty that your client will incur if they take a non-qualified distribution. A 10 percent penalty, for example, is a valid option when facing a financial crisis due to your separation and divorce.

It is important to discuss these various scenarios with your clients and determine the exact tax penalties for their given situation in order for them to be fully informed about their options. If your client has a 529 plan, it shouldn’t just be assigned to the children, and a custodian of the account shouldn’t be assigned arbitrarily. Some of your clients may have significant assets in their 529 accounts or they could desperately be in need of these funds right now for a number of reasons. Either way, 529 plans deserve a second look.

Kristen Shearin, attorney and CDFA, is a partner at Passenant & Shearin Law, a family law practice in Charlotte, NC. For more about Kristen, visit www.psfamilylaw.com.