The Tax Cuts and Jobs Act of 2017 (TCJA) made two significant changes that have a direct impact to post-divorce college planning.
Alimony payments are no longer taxable to the recipient, and no longer tax deductible to the payor.
College savings plans (also known as 529 plans) can now be used for K-12 education (up to $10,000 per year). This can be used for public, private, or religious schools.
While these two changes are seemingly unrelated, their intersection provides some potential pitfalls for divorcing couples who are unaware of their impact. To better understand those concerns, we need to look closer at the direct impact of each of these changes.
Changes in alimony payment taxation
Prior to TCJA, alimony was an above-the-line tax deduction for the payor, while it was taxable income to the payee. Since people who pay alimony are (almost always) higher income earners than the recipients, there usually was a difference in tax brackets between the two spouses. Shifting the income tax from the higher tax bracket to the lower tax bracket earner meant that there was more ‘after-tax’ income to divide between the two spouses.
The below case study example, first published in the CPA Journal, might help to better visualize this:
Olivia Harper, a successful actress, and Mark Harper, a struggling writer, will be getting a divorce under an agreement calling for Olivia to pay Mark alimony payments totaling $50,000 a year. After the divorce, Olivia will be in the 37% tax bracket, and Mark in the 22% tax bracket.
If they divorce in 2018, Olivia’s $50,000 payment to Mark will be deductible and will reduce her tax by $18,500 ($50,000 × 37%), but the payment will be taxable to Mark, costing him $11,000 ($50,000 × 22%). With Olivia’s $18,500 tax advantage in mind, Mark’s attorney may well expect to gain concessions in other aspects of the couple’s settlement agreement.
In essence, because there was more ‘after-tax’ income to go around, there were more opportunities for both sides to negotiate.
However, for all divorces that occur after December 31, this completely changes.
For the Harpers, it looks like this:
The after-tax cost of Olivia and Mark, as one unit, will be $31,500 under the 2018 rules ($50,000 − Olivia’s $18,500 deduction), but will increase to $39,000 under the 2019 rules ($50,000 − $11,000 not taxed to Mark). Thus, before the TCJA rules take effect in 2019, there will be $7,500 more after-tax money between them to fund a settlement agreement, and a purely tax perspective would seem to favor finalizing the agreement in 2018.
For the Harpers, the $7,500 difference between a 2018 divorce agreement and a 2019 one represents a sort of tax arbitrage. One that’s no longer available:
Alimony is no longer a tax deduction for the high-income earner, and no longer taxable income for the low-income earner.
This means that Uncle Sam gets a bigger slice of the pie (by taking a bigger share of the taxes), and there is less ‘pie’ to negotiate over.
The expansion of qualified expenses covered by college savings plans
Section 529 plans are named after the Internal Revenue Code Section 529-Qualified tuition plans. This actually covers two different types of state-sponsored programs: prepaid tuition plans, and college savings plans.
Originally, Section 529 primarily focused on ‘qualified higher education expenses,’ meaning college costs. TCJA’s broadened the meaning of qualified higher education expenses to include: “expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.” In other words, if you want to use a 529 plan (holding tax-advantaged funds) for your child’s education before college, you now can do so.
While this presents expanded opportunities, there are even more complexities and challenges. This is particularly true when divorcing spouses might not be on the same page regarding what’s best for their children’s education.
Now that we better understand the direct impact that TCJA has on two seemingly different parts of personal finance, let’s take a look at some of the second-order effects:
Less money “in the pot” means that “win-win” scenarios are less likely to happen.
This is not really a second-order effect, but rather a deeper look at the previously stated impact TCJA has on alimony taxation.
To use the Harpers’ example above, the $7,500 lost annual ‘arbitrage opportunity’ simply means there is less money to go around after Uncle Sam gets a bigger slice of the marital pie.
Less pie to go around means that there is less opportunity for win-win settlements. Having fewer win-win opportunities means that there are more things divorcing spouses might consider fighting over. Like college savings plans.
College savings plans could become a battleground for divorce settlements
Pre-TCJA, college savings plans were simply an often-overlooked asset that many divorcing couples didn’t pay much attention to when determining equitable distribution. In most cases, each spouse would discuss (or litigate) division of assets. 529 accounts, likely having the intended child designated as the beneficiary, were often an after-thought. Depending on the state, either the settlement would split the asset down the middle, or the accounts might go to the custodial parent.
In these ‘less complicated’ times, there were ‘only’ a couple of obstacles to a well-intentioned parent trying to safeguard their child’s assets:
529 plans are state-specific. So are divorce laws. This means that it’s harder to get clarity by doing your own research online.
529 accounts actually belong to an adult (meaning one of the parents), not the child. This means they should be considered as part of the equitable distribution, not assumed to be the child’s property.
The adult who owns the account can change beneficiary designations at any time, for any reason. Unless specifically written in a divorce settlement.
Divorce settlements are not always as specific as they need to be. In fact, they almost never are, unless required by statute, written by at least one diligent attorney, or overseen by a detail-oriented judge. Don’t count on your lawyer or judge to cover all the bases for you.
With these facts in mind, here are some of the plausible (and sometimes, actual) examples where 529 plan division has gone (or could have gone) awry:
Parent ‘hides’ money in a 529 plan to circumvent equitable distribution, then withdraws the money (minus taxes and penalties on accrued earnings)
Ex-spouse marries new spouse, then re-designates step-children as beneficiaries.
When you add the additional ‘options’ of using 529 plans to fund private K-12 education, you can imagine these additional possibilities:
One spouse uses 529 plan to send children to private school with religious teachings. Other spouse, who does not share same religious beliefs, sues.
Ex-spouse remarries, then empties 529 plan to send stepchildren (or subsequent children with new spouse) to private elementary school. Other spouse, who had been paying into the 529 plan, is still responsible for sending their children to college.
Needless to say, the additional options present a new level of complexity, which leads us to our next point.
Having a “full education plan” has never been more important.
At its core, education planning consists of an effort to reconcile the desired education with the resources available to provide that education. Until this recent tax law change, most families would do something along the lines of the following:
Determine whether they could afford private school. If not, they would find the best available public education.
Save as much money as they could (or wanted to), either through a prepaid tuition program, college savings account, or other means.
Use saved money to pay for college expenses.
Now, in families where private K-12 education is a viable option, it’s important for families to ensure that their funding plan covers the expected education, to include anticipated college expenses. Naturally, this assumes that both spouses have roughly the same overall goals for their children. Or at least some basic assumptions around shared beliefs and expectations.
Divorcing spouses cannot make this assumption. In most cases, two divorcing spouses are not going to agree on all the details. Many times, the spouses might not even have shared beliefs.
At the very least, though, they should have shared expectations. Those expectations should be recorded in detail, in the divorce settlement. Starting with specifying the intended use of all college savings account assets.
Every judgment needs to clearly specify the intended use of all college savings accounts.
Property division laws can differ depending on your state. So you should check with your lawyer to see if there are any laws that specifically address the division of 529 plan assets.
Generally speaking, many family law attorneys will tell parents to split their 529 plans. This addresses the equitable distribution question. But there are two big things that this doesn’t address:
Complexity. I have 3 children, with 1 separate 529 plan for each child. If my wife were to get divorced, then blindly follow this advice, we would now have 6 529 plans. Plus the paperwork involved in opening those accounts. On top of everything else on your plate, this represents another opportunity for something to slip through the cracks, even for well-intentioned, co-parents. Plus, it doesn’t address the other real issue.
Possible ‘mis-use’ of ½ the plan assets. Well, this is better than misusing all of the assets. This doesn’t necessarily mean that the assets were spent on your ex’s car, or new children. But perhaps your ex, who has primary custody, decides to spend their half on private school. Which you don’t agree with. Leaving only ½ the expected money for college. Perhaps the term ‘mis-use’ could be applied to any spending that’s done in a way you weren’t expecting when you divorced. And vice versa.
While it might still be a good idea to split the 529 plans, a more effective way to ensure clarity might be to have the divorce settlement specify what the intended use is for each 529 plan. That way, there can be no misconceptions about what is considered bad behavior. Below are some considerations you might want to discuss with your attorney (depending on what your state laws allow):
Acknowledging the intended use of the 529 plan(s) as the ‘child’s asset,’ documenting it accordingly, and accounting for this in the equitable distribution worksheet.
Restricting the use of funds so the account owner can only use them for education expenses for the account’s stated beneficiary.
Documenting which education expenses are ‘allowable,’ and which are not. Specifically, are K-12 education expenses okay, or no? If so, are there any restrictions on which type of education (private, religious), this money is used for?
Restricting the account so that the current beneficiary cannot be changed until he/she has completed the expected level of education or has reached a certain age.
In cases of multiple children, clearly specifying how (and when) to change beneficiaries so that surplus funds are carried over to the next child.
Specifying what is to be done with surplus funds once all children have reached the desired level of education.
You might not agree on everything, but that’s what attorneys and mediators are for. At the very least, if it’s written in the divorce settlement, you have some recourse in the case things take an unexpected turn. Like if someone doesn’t uphold their share of the bargain.
Each divorce settlement should clearly state the proper current AND future financial obligations of each parent.
Not only should the divorce settlement specify what the 529 accounts should pay for (or more importantly, what they should NOT pay for), but they should clarify what each parent is responsible for. Addressing both of these potential pitfalls will help cover most of the foreseeable issues that could arise.
Possible conversation points (with your attorney) could include:
What is the expected K-12 education for each child? What financial obligations are associated with this expectation?
What financial responsibilities, if any, do the parents wish to assume for college?
Is each parent supposed to pay a specific dollar amount, or fund a certain level of education?
How does the funding work? Does the parent continue to put money into a college savings plan, pay the college directly, or set money into a separate account for the child’s benefit?
From a financial aid perspective, assets owned by the non-custodial parent are treated differently from assets set aside for the child (like in a trust account) or owned by the custodial parent. How can parents coordinate their funding efforts to maximize available college aid? Is this even a consideration?
Hopefully, you and your soon-to-be ex-spouse are able to work out the disagreements regarding your children’s education goals. At the very least, having a better understanding of how the new tax law might impact your post-divorce college planning is a good first step.
Working with a Certified Divorce Financial Analyst® is a good way to take that first step towards a more financially sound future. Schedule your appointment with Lawrence Financial Planning today. We will always give you professional advice and walk with you every step of the way. We invite you to one of our monthly Divorce Workshops. Find the details on Facebook and Instagram, or visit our website. If you need help putting together the financial pieces of your divorce, contact us. We can schedule a no-cost consultation to see how we might be able to help us.