Careful college and tax planning through a divorce transition can result in the preservation of more of the income and assets of both parents and their children. The preserved income and assets can be used to fund future college costs of the children.
Property Settlements
When property settlements are equitable, the current fair market value of the assets being divided may be equal. However, the financial risks and tax consequences related to the assets may not be equal, so these factors should also be considered.
For example, a limited partnership interest could soon lose much of its value, while a money market fund would retain its value. The spouse who is to be responsible for college costs would be reluctant to have an asset that, as part of their settlement share, has a value that could decrease substantially. In addition, there are some assets that create a large tax liability if liquidated for college costs. It is advisable that the spouse responsible for college costs receive assets that have no potential for loss, such as CDs. The responsible spouse shouldn’t need to cope with a large tax liability when the children begin college.
Tax consequences can be significant in a divorce. There will be situations in which one spouse will be in a lower tax bracket than the other. In such cases, a property settlement can be structured to take advantage of the tax differential by assigning more gains to the lower bracket spouse so that they will be taxed at the lower rate. The tax savings can contribute to the funding of college costs.
Alimony
Alimony consists of direct payments to the ex-spouse plus such indirect payments as medical insurance premiums, mortgage payments, property taxes, homeowners insurance premiums, utilities, life insurance premiums, and the educational expenses of the ex-spouse. Since total alimony is deductible from the gross income of the spouse paying the alimony and is included in the income of the spouse receiving the alimony, the deduction for alimony is an opportunity to shift income from the higher to the lower tax bracket spouse. The tax benefit created by this differential can also contribute to college funding.
Qualified Domestic Relations Orders
Future assets, such as pensions and retirement benefits, are excluded in the construction of a divorce settlement. A “Qualified Domestic Relations Order” (QDRO) is required for an ex-spouse to receive an interest in the former spouse’s retirement benefits. A QDRO is a judgment, decree, or court order that provides an ex-spouse with the right to receive benefits from a qualified retirement plan or tax-sheltered annuity. QDRO’s do not apply to IRA’s. Rules affecting IRA’s are covered separately in IRC Sec. 408 (d)(6).
A QDRO specifies the amount of retirement benefits to be paid or rolled over to the spouse participating in the retirement plan, the ex-spouse, and the children. The retirement account benefits are taxed to the ex-spouse when they are paid out. Benefits paid directly to children are taxable to the spouse who is participating in the retirement plan.
In order to maximize the tax benefits that arise from transferring pension and retirement plans to the ex-spouse and children, the spouse who is participating in the retirement plan should consider the tax consequences. The agreement should be structured to maximize the income derived from shifting tax benefits. If done properly, the distributions to the ex-spouse will be considered part of alimony so that the ex-spouse, rather than the spouse participating in the retirement plan, will be taxed on the distributions as income
The 10% early withdrawal penalty on withdrawals before age 59½ does not apply to payments made to an ex-spouse under a QDRO. In addition to the income tax savings, the distributions to the ex-spouse avoid gift and estate tax. The tax savings can be used as a source of funds for college.
A QDRO distribution can be made to the ex-spouse before the time that the spouse participating in the retirement plan is eligible to receive distributions because he or she has reached age 59½. Such distributions could also be used as a source of funds for college. In cases in which child support payments decrease when a child reaches a certain age, leaves home, or marries, distributions are considered part of child support.
A QDRO can be structured to have the distributions paid directly to the children to be put aside for college expenses until they reach a certain age. The receiving ex-spouse would be taxed on the distributions. The spouse participating in the retirement plan could claim an income tax deduction for the payments. Thus, the net effect of the transaction would be the shifting of income and the associated tax liability to the ex-spouse.
QDRO Example:
The parents are getting divorced. The divorce agreement requires the father to make payments to the mother until their child finishes college. The mother is concerned about the father’s willingness to meet this financial obligation, so she obtains a QDRO against the father’s 401(k) plan to secure the college expense obligation. If the father defaults on the college expense obligation, the mother can recover the funds from the father’s 401(k) plan.
Prenuptial Agreements
If an individual plans to remarry after a divorce, he or she should execute a prenuptial agreement. Such an agreement can preserve funds for the college costs of the children of the prior marriage. Absent a prenuptial agreement, the ownership and disposition of property in the divorce will be determined by state courts. The court decision may be contrary to the original intention of the parties on the disposition of assets to cover the college costs of the children.
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