College 529 plans are a relatively new way to save for college education expenses. Many divorcing families have 529 plans that need to be addressed in their property settlement agreement. This article highlights two specific areas regarding 529 plans in divorce - deductibility of losses and the use of plan assets to fund educational expenses.
With the stock market down about 50% from previous highs, many college 529 plans are worth less than the amount that was contributed. In 2008, the IRS changed rules to allow owners to take the amount of their loss (contributions less current value) as an ordinary loss on their Federal income tax return if a plan is completely liquidated. This could be an effective strategy for many divorcing families.
However, there are many caveats to be aware of (you didn’t think the IRS would make this simple, did you?). First, the proceeds should not be reinvested in a 529 plan for at least 60 days. Second, the ordinary loss is a miscellaneous itemized deduction. To benefit, you must itemize your deductions and the amount of your total miscellaneous itemized deductions must be in excess of 2% of adjusted gross income. However, if a taxpayer is subject to the alternative minimum tax (AMT), they likely would not benefit from the loss at all. Further, if the contributions to the 529 plan provided a state income tax deduction, then those deductions would be lost. Last, grandparents or parents who used gifting rules to make a large contribution to a 529 could be prohibited from providing another gift for a certain number of years.
In general, 529 plan assets are utilized to fund education expenses until they are exhausted. After, parents make contributions in accordance with the statutory factors at the time of the event or based on percentages agreed upon during divorce. If you are like most and choose to allow one party to retain control of 100% of 529 plan assets, I recommend you include restrictions on liquidations and changes in beneficiary.
However, I suggest an alternate scenario should become commonplace, as it may achieve greater equity. 529 plan assets should be distributed, generally 50/50, to the parents. Each parent would utilize their share of 529 plan assets as they deem appropriate, unless their agreement dictates certain restrictions. Without restriction, some parents may choose to completely liquidate the plan and realize losses. Perhaps some would change the beneficiary designation.
Then, at the time the child enters college, each parent would contribute in accordance with whatever case law applies at that time. Note that Newburgh does not include a factor relating to college savings or other assets that may have been “set aside” by the parents. In fact, nowhere is there a statutory requirement indicating 529 plan assets should be exhausted first.
Let’s use an example: As a result of restrictions in their agreement, both parents kept their 529 plan assets untouched since their divorce and now have equal sums of $25,000. Dad’s income is $150,000 and he has $250,000 of other assets. Mom has $50,000 of income and $150,000 of other assets.
How should they contribute to college? Do you think the first $50,000 of education expenses should be paid via $25,000 of 529 plan assets each? If not, then you should consider this alternate settlement scenario to achieve an equitable outcome with respect to college expenses.
More than ever, during this difficult economic time, advisors need to help divorcing couples take advantage of all the tax breaks available. If 529 plan assets are less than what was contributed, a complete liquidation should be considered.
Further, as a family law community, we need to re-think the equitable distribution of 529 plan assets. Often, they should be split equally by the parties and college expenses should be paid by parents at the time of the event in accordance with the then effective statutes.
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