Divorce and College Funding
Divorce involves complicated issues involving all financial aspects of life from living situations, to retirement, healthcare, income and support, taxes and estate planning. Often overlooked in divorce is planning for the children’s college, especially their qualification for need-based financial aid. Divorce attorneys are not always aware of the financial consequences of settlements and their impact on a child’s eligibility for financial aid.
I hope to shed some light on the nuances involved in college planning especially for those using 529 plan funds and for those seeking need-based financial aid.
Need-Based College Financial Aid
Need-based college financial aid considers only the ability of the student and h/her family to pay the cost of college tuition. It is distinguished from merit financial aid which is based upon the achievements and academic performance of the student. It is awarded based on the assets and income of the prospective student and h/her parent(s). Need-based aid may be applied for from both private and federal student loans and grants and this is where the Free Application for Federal Student Aid or FAFSA plays a role. By filling out the FAFSA, students will learn if they qualify for aid from federal and college sources. Merit awards are not influenced by FAFSA.
529 College Plans
To be sure, not all states consider 529 plans as assets that are confirmed to the beneficiary in divorce proceedings. Some require that half of the funds in the account be offset by payment from the parent who is the account owner to the parent who is the non-owner. If this is stipulated or court-ordered, it is better to make an offset payment with other funds rather than disburse the funds and incur the 10% penalty and potential income tax consequences if not rolled into another 529 plan for the beneficiary.
New Legislation-FAFSA
It is even more important than ever to consider the implications involved with child support and division of assets because of the recent changes to legislation regarding the FAFSA.
Custodial Parent Re-Defined
Only one parent is required to file the FAFSA. New legislation goes into effect for the 2023-24 school year (taking into consideration the prior-prior year (PPY) tax information in determining income levels). This is essentially the use of two-years’ prior tax information on the FAFSA, which mean that on October 1, 2022, applicants would be a looking back to October 1, 2021 when submitting FAFSA applications for the 2023-2024 school year.
In the past the custodial parent was defined as to the domicile where the child lived most (that is greater than 50% of the time during the year or a minimum of 183/365 days). In many divorce cases, the custodial parent is an unmarried parent with the lower income. Savvy parents optimizing this rule to achieve greater financial aid would be sure that the child stayed with the lower-income parent who had fewer assets the majority of the time.
This would usually increase eligibility for financial aid and decrease what was once called the expected family contribution (EFC) and now is renamed to “Student Aid Index” or SAI in order to receive greater financial aid. This index is a number used by the government and college financial aid offices to determine the student’s need-based aid eligibility. It essentially identifies what the family would be expected to contribute in proportion to the aid that would be provided.
If the student lived equally with both parents, as defined by the settlement agreement, the custodial parent would be defined as the parent who provided the most support.
The new legislation does away with the physical place or the typical circumstance of divorced families and simply defines the custodial parent as the one who provided the most support. Here is a link to IRS Worksheet to determine support. Typically, but not always, this translates into whoever claims the child on their tax return. FAFSA will apply this definition and likely, will rely on tax returns when making the determination for student aid effective for applicants for the 2023-24 school year.
The purpose of the change is to better align the FAFSA with the Internal Revenue Service rules. Since the definition of support encompasses not only child support but also the fair market rental value of housing and proportional share of household expenses, support calculations can be more complicated than presumed.
Although it may be anticipated that a parent may falsely claim a child on their taxes even though they didn’t provide the most support, to increase the eligibility for greater financial aid, this would require the cooperation of the supporting parent to agree. It is typically an unlikely scenario, since often the parent who pays child support often wants to claim the children as dependents to reduce h/her tax liability.
Parents might also appeal FAFSA’s reliance on tax returns using a multiple support agreement document which allocates who claims a child as a dependent without regard to who provides more financial support. This multiple support agreement may also stipulate that parents rotate providing financial support.
Income, Assets, and Funds Provided by Others
529 college savings plans that are owned by the custodial parent are reported as parent assets on the FAFSA filed by the custodial parent. Any distributions from these parent-owned accounts are ignored by FAFSA in determining eligibility and amount of aid.
If the custodial parent has remarried at the time of filing the FAFSA, the stepparent’s income and asset information for the base year (two-years prior) must be reported on the FAFSA, even if the custodial parent and stepparent weren’t married at the time. And, more importantly, any 529 plans owned by the stepparent would also be reported as parent assets for that child. Again, distributions from the plans are ignored.
Importantly, parent assets only reduce aid eligibility by 5.64% of the asset value; distributions do not count. However, if funds are provided by anyone outside the nuclear family for the beneficiary child, the funds are not reported as assets and will no longer penalize the child’s eligibility for financial or the amount of aid received.
In the past, FAFSA treated the distributions from such nonparental plans (e.g. grandparent-owned 529s) as untaxed income to the beneficiary. However, with the new legislation, FAFSA will not consider whether nonparents have helped defray college costs commencing with the 2023-2024 school year. This is a huge savings for the child, potentially boosting financial aid considerably, because up to 50% of this untaxed income was considered in the past and it will no longer be considered.
Divorce Implications and Mitigation
There are many implications of 529s and college savings issues during the divorce process when dividing assets and when determining the final settlement agreement.
The owner of the 529 can be changed to the custodial parent to optimize the financial aid eligibility and increase the aid awarded. All plans allow a change of ownership pursuant to divorce.
Financial advisors often suggest deferring distributions, if possible, and not tapping into noncustodial parent plans until January 1 of sophomore year of college (assuming 4 years to obtain a degree) because the income will not be counted since FAFSA uses the income from the prior-prior year.
Contributions to a 529 may be made to the custodial owner’s 529 rather than a noncustodial owner’s 529. Specifying this in the marital settlement agreement will allow for assets to accumulate in the proper account. It is also prudent to specify in advance who will cover higher education expenses and in what percentage or dollar amount of total costs. This helps with planning for college savings and contributions to the 529, besides identifying responsibility and ensuring accountability for the children’s college needs.
If funds are already in a noncustodial parent’s 529, that parent may rollover one year of funds to a custodial parent-owned 529 after the FAFSA is filed. Since the two-year’s prior tax return is used, this rollover will not get reported as an asset on the FAFSA and the distributions would still be ignored as income. It is important that both of the 529s be in the same state to avoid recapture rules that some states apply if income tax deductions, allowed by some states, had been taken for contributions to a 529 plan.
The owner of a 529 plan has full, unfettered access to the account and may make a non-qualified distribution from the 529 plan. While the penalty and taxes would apply, this parent could usurpe the assets intended for the beneficiary. If there is a risk of this happening, the marital settlement agreement could include provisions that restrict that access and require annual statements be provided to the non-account owner parent for oversight.
If there is remarriage, there is a possibility that the 529 plans might be considered marital assets and subject to division in the event of a future divorce. To avoid this, a prenuptial agreement should specify that the respective owners of the 529 plans retain ownership and the assets are explicitly designated and preserved for their respective beneficiaries or for whomever the owner deems as beneficiary.
The marital settlement agreement (MSA) should also expressly state who would be a successor owner in the event of the death of a parent-owner. While parents may usually be the best people to be successor owners, the marital settlement agreement should at a minimum specify who will be controlling the money and ensure that the beneficiary’s interest is paramount.
Another consideration for the MSA is who will be able to deduct the American Opportunity Tax Credit (AOTC). Worth up to $2,500 it is refundable (up to 40%) which means 40% will be refunded even if no tax is owed (applicable in the case of someone receiving alimony which is non-taxable). Eligible expenses include tuition, books, and required fees, but not room and board. Importantly, it starts to phase out at $80,000 AGI for single filers and $160,000 for joint returns. Form 1098-
T must be received from the college, so it’s beneficial to have the claimant’s address on file at the school.
Alimony
Any spousal support or alimony attributed to divorces in 2019 or later are not tax-deductible nor taxable as recipient’s income. Alimony would not have been included in the adjusted gross income (AGI) of the recipient spouse, thus lowering the impact for FAFSA. However, in most cases, this will be a non-issue in FAFSA eligibility and aid going forward with the new legislation, since typically alimony is paid to the lesser-earning spouse not the higher-earner. Even in those rare cases where greater financial support is provided by the custodial parent who may also be receiving alimony, the alimony would not be counted since it is expressly excluded for income tax purposes.
Death of Custodial Parent
In the event of the custodial parent’s death, the noncustodial parent is responsible for completing the FAFSA. This is true if the student is still listing the stepparent’s home as h/her residence. If the stepparent has not legally adopted the student, the stepparent is no longer considered a parent and the income attributed to the stepparent is no longer counted on the FAFSA as parental income. However, any financial support the stepparent provides is considered untaxed income to the student and is reported on the student’s FAFSA.
CSS Profile
In addition to or in lieu of FAFSA certain colleges may require the CSS Profile to be completed. Some of these colleges require information from both of the biological parents when assessing eligibility and awarding financial aid. They also treat divorce and separation differently from FAFSA, so it Is important to review their instructions, especially for the noncustodial parent. The CollegeBoard has information on their website to guide divorced applicants through this process that you may access at CollegeBoard guide to CSS Profile.
Summary
As you can see the implications for divorce are great regarding saving for college, the use of 529 college savings plans, applying for need-based aid and dividing assets already earmarked for college. These considerations are especially important with the passage of the FAFSA overhaul.
College Financial Prep offers assistance not only with completing the FAFSA but also the CSS Profile which treats divorce and separation differently. For help in navigating the college financial aid process after divorce they can be reached at College Financial Prep.
There are some benefits to the redesign on the whole, but in the case of divorce circumstances, the proof will be in how this plays out within the divorce proceedings. It is extremely important to consider all nuances of the implications involved when dividing assets, planning ahead for college, as the divorce team is designing marital settlement agreements.
