Saving for College: What Happens to a 529 Plan When You Divorce?
Your children may be too young to even know what career they would like to pursue, let alone know which college they want to attend. But if you and your spouse, like so many other parents, set up a designated 529 college savings plan, a tax-advantaged investment account used to help parents squirrel money away funds to cover the eventual cost a child attending college, you may be wondering what’s going to happen to this money now that you are getting a divorce. Your family’s situation is unique, of course, but here are a few common possibilities for dealing with a 529 plan during a divorce.
Freeze the Account: Essentially, money in a 529 plan can be withdrawn by an account owner at any time for any reason – for example, to buy a car, pay for a vacation or for another purpose – though a tax penalty is assessed for any non-education spending. If you and your spouse are both listed as owners, one or the other of you can withdraw money. This may not have been an issue during your marriage, but now that you are divorcing, keeping this kind of joint account may be tricky.
As a first step, freezing a 529 plan account means no more deposits are made to the account and no withdrawals can be made by an account owner. The money already in the account can collect interest, but can only be used toward education for the child designated. This can prevent a disgruntled spouse from making a bad decision during the coming years and safeguard the money for its intended use. Freezing the account also prevents a parent from using account funds to pay for the education of a child from a new marriage.
Create Separate Accounts: If it’s thought to be a better solution, a couple can decide in mediation (or a judge can order) that an existing 529 plan be split into two new 529 plans, with each parent named the owner on one account. For example, if a 529 plan had $5,000 in assets, each spouse would be responsible for a new account containing $2,500. By setting up a separate owner for each account, that spouse would be responsible for making all investment decisions for that account and making deposits or deciding on withdrawals.
Setting up two separate accounts could be helpful if the couple’s divorce settlement outlines how much each will need to contribute financially towards the child’s college costs. There is no tax penalty for moving money into new 529 plans.
Liquidate the Account: Depending on the terms of a divorce, some couples may decide to liquidate the account and divide the money as they would other martial assets and joint accounts. In this case, tax penalties would apply and may, in some cases, make it more of a financial burden than bonus to liquidate, so consider this option carefully.
Deal with Leftover Funds: Another issue that should be discussed or formally written into a divorce decree is what to do with money left over after the child completes his or her education. Possible options include one of the parents using funds to return to school or a sibling using leftover funds, or simply keeping the leftover money in the event the child, at some later point, decides to pursue an advanced degree.
For more on the topic of college, kids, and divorce, see, “Does Paying For College Tuition End the Need For Child Support?”