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529 Plans And Divorce

One of the most stubbornly perplexing investments couples encounter in their divorce is the 529 Plan.  The typical investment goal of the plan is college funding, but it can be used for many purposes.  But who owns it?  Is it marital?  What are the tax implications of liquidating?  Can you divide it? There are probably a half a dozen other questions that may come to mind in contemplating how to deal with 529 plans and divorce. Let’s see if we can help demystify this unique investment.

First of all, it might surprise you to learn that 529 plans, named after an IRS code, can be used for just about any purpose imaginable.  They are not just for college.  However, they have significant advantages over other investments when used for college or post-secondary training.   Most withdrawals for college and post-secondary expenses are free from income taxation, and all accumulation, or growth, in the plan is exempt from income or capital gains tax, which is known as tax-deferred growth.  They also have very high contribution limits, often feature income tax deductions, and you can use any state plan to pay for any college – you are not limited to colleges within the state that the plan is sponsored.

But you do not have to use a 529 plan for education.  If you use it for purposes other than college or post-secondary expenses, you must pay a 10% penalty on earnings in the investment – not principal contributions that were made, just growth.  While that is generally a penalty you want to avoid, the truth is, if you were to receive positive average returns over the life of the plan, it is possible that there would still be significant growth available for withdrawal even after paying the 10% penalty.

A 529 plan is established by one adult sponsor known as a “donor,” who is the owner.  It cannot be jointly owned.  Typically, one spouse, or one grandparent, will be the donor of the plan and will designate one child as a beneficiary.  You may change a beneficiary at any time, without restriction, which is useful if one child is offered a scholarship. One caveat to beneficiaries is that they must be family members to avoid the 10% penalty on qualified withdrawals.

One donor must remain the owner and ownership cannot be transferred.  Unfortunately, simply owning a plan for the purposes of sending the kids to college does not compel that spouse to use the plan for that purpose.  If a parent chooses, they can use the funds for any other purpose, subject to the 10% penalty on growth.  For this reason, the parent that retains the plan usually has those investments added to their portion of the marital estate.

A key issue for divorcing parents is that if you take funds from, or fully close the plan, to distribute part or all the funds to a spouse, a 10% penalty on growth will be assessed.  Once they go in, only withdrawals of the principal avoid the 10% tax.  Another contentious issue?  How about grandparent contributions sent to a plan owned by one of the divorcing spouses?  How do you account for them in divorce?

In most circumstances, it should be possible to divide a 529 plan as a result of divorce.  If you or your spouse have a 529 plan, check with the plan sponsor to learn about their procedures and obtain any special paperwork needed to divide the accounts without taxation.

Practically speaking, 529 plans are considered marital assets.  Closing the accounts can be an option, particularly if there has been significant growth over a period of time and the 10% penalty takes only a small bite out of it.  Splitting accounts is an even better option.  Overall, parents need to trust that the plan will be used for college or consider closing the accounts, but some parents have difficulty with trusting.  If the plan remains intact, it should be placed in the assets column of the donor, as that spouse can choose to utilize those funds for any purpose they choose.  On the bright side, if used for college or post-secondary training/education, 529s are a terrific investment strategy and offer benefits not offered elsewhere.