There can be issues with college savings that the spouses had initiated together even in amicable divorces, Divorce attorneys are legal experts but not financial aid experts. They may not be aware of all of the consequences of divorce on a child’s eligibility for financial aid or the nuances of need-analysis formulas. For that matter, they may not be familiar with the substantial tax consequences of choices made in a divorce settlement. Careful planning during a divorce transition can safeguard and augment income and assets for parents and children, facilitating the funding of college educations.
Equitable Property Settlement
When property settlements are equitable, the fair market value of the assets being divided is approximately equal. However, the financial risks and tax consequences related to the assets may not be equal. Any imbalance can be remedied.
For example, a limited partnership interest might lose much of its value, while a money market fund would retain its value. The spouse who is to be primarily responsible for college costs (the responsible spouse) 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 responsible spouse receive assets that have no potential for loss, such as CD’s and money market funds. Ideally, the responsible spouse won’t need to cope with a large tax liability when the children begin college.
Tax consequences can be significant in a divorce. There are likely to be post-divorce 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 a child’s college education.
529 Plans in Divorce Settlements
It is difficult to predict how a divorce court might treat a 529 college savings plan during the division of marital assets. Some courts treat a 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 plan is considered an asset of the account owner, even if it is intended to be used to pay for the college costs of a child as beneficiary. The account owner can change the beneficiary or even take a non-qualified distribution.
Alimony as a Factor in Planning
Alimony consists of direct payments to an ex-spouse plus such indirect payments as medical insurance premiums, mortgage payments, property taxes, homeowners insurance premiums, utilities expenses, life insurance premiums, and any educational expenses of the ex-spouse. Since total alimony is deductible from the gross income of the spouse paying the alimony and is included as income to 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 from the construction of a divorce settlement. A Qualified Domestic Relations Order (QDRO) is required for an ex-spouse to receive an interest in his or her former spouse’s retirement benefits in a pension or 401(k) plan. 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 ex-spouse and/or children from the spouse participating in the retirement plan. The retirement account benefits are taxed to the recipient ex-spouse when they are paid out. Benefits paid directly to children are taxable to the ex-spouse who is participating in the retirement plan.
In order to maximize the tax benefits that arise from transferring pension and retirement plans to an ex-spouse and children, the former spouse who is participating in the retirement plan should consider all tax consequences. The QDRO should be structured to maximize the income derived from the shifting of tax liabilities. If done properly, the distributions to the ex-spouse will be considered part of alimony so that the ex-spouse, rather than the former spouse participating in the retirement plan, will be taxed on the distributions as income.
A QDRO can be structured to have the distributions paid directly to the children for college expenses when they reach age 18. The receiving children would be taxed on the distributions at, one may assume, the lowest tax bracket. The former 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 children in a lower tax bracket. The tax savings could be provided to the children as gifts to be spent on their education.
As an example of a QDRO, let’s assume that 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 legally recover the funds from the father’s 401(k) plan.
IRA Retirement Plans
The 10% penalty on IRA withdrawals before age 59½ does not apply to payments made to an ex-spouse. In addition to potential income tax savings, the distributions to the ex-spouse are exempt from gift and estate taxes. In cases in which child support payments decrease or terminate when a child reaches a certain age, leaves home, or marries, distributions cease.
Prenuptial Agreements Are Recommended
If an individual plans to remarry after a divorce, he or she is advised to 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 a divorce will be determined by state court. The court’s decision may be contrary to the original intention of the parties on the disposition of assets to cover the college costs of the children.