If this one simple condition isn’t specified in your child’s 529 College Savings Plan, it could be a disaster in the event of a divorce.
Fade In:Scene: Norristown Law Firm
A divorced father of an 18-year-old comes in seeking legal advice. He is livid with his ex-wife and his divorce lawyer. The divorce was finalized years ago, and he wants an opinion on whether he can sue his ex-wife, or if his attorney committed malpractice because the funds that were in the 529 College Savings plan account were spent by his ex-wife.
This man’s issue is intriguing, because the obligation to contribute to him and his ex’s child’s college expenses requires interpretation of their property settlement agreement; there is no statutory obligation in Pennsylvania to contribute to a child’s college costs. The property settlement agreement lists the parties’ assets and liabilities. The asset list includes an entry for $200,000 in the 529 college savings plan account held by the ex-wife, with the child as beneficiary.
Ok, so what’s the problem?
The agreement states the parties will each contribute to the child’s education after “initially using all the child’s college savings.” The problem is his ex-wife owned the 529 plan account; the child was simply the beneficiary and not the owner of the funds in the 529 plan account. Nothing in the agreement provided restrictions on the ex-wife’s use of the 529 plan account assets.
Is it malpractice?
In those cases where lawyers fail to address the 529 college savings plan funds owned by one of the parents, there is a real risk of malpractice. The father tells you that his ex-wife withdrew all the 529 plan funds to purchase her new Porsche and take wonderful trips to Europe. He wants to know if he can sue under the agreement or under the Uniform Transfers to Minors Act, or UTMA. The family lawyer must be savvy about the difference between the UTMA accounts and trust accounts, as opposed to 529 plan accounts. In this hypothetical, the lawyer handling the father’s divorce failed to properly protect the interest of the father, who assumed the child’s 529 plan college funds were secure.
How does a 529 College Savings Plan work?
In 1996, the United States enacted Section 529 of the Internal Revenue Code, establishing a qualified tuition program whereby states or colleges offer college savings plans. The purpose of the 529 plan account is to provide a vehicle to save for college in a tax-advantaged way.
Anyone (the account owner, the beneficiary, relatives, friends, etc.) can contribute after-tax dollars to the account, where earnings grow tax-deferred while the funds remain in the account. Pennsylvania taxpayers will receive a state income tax deduction for any contributions to a 529 plan account, up to the annual gift tax exclusion.
Earnings will be tax-exempt (from both federal income tax and Pennsylvania state income tax) if used for qualified higher education expenses of the designated beneficiary at an eligible educational institution or used for a qualified transfer/rollover beneficiary’s education. If the earnings are used for non-qualified purposes, then they are taxed at withdrawal as ordinary income to the account owner or beneficiary and subject to a 10 percent federal tax penalty (with limited exceptions).
What should have been done?
The divorce lawyer must advocate for the non-owner parent, since the account and its earnings are subject to withdrawal by the owner. The key is the owner of the account retains control of the funds. Under the qualified tuition program, only one person is the owner. Although a beneficiary is named, the beneficiary has no right to invoke the protective language of the UTMA or trust provisions that would protect a beneficiary.
To add salt to the wound, one parent will often open a 529 plan account as owner, and others will contribute gifts to the beneficiary by depositing in the 529 plan account. Those gifts may come from anyone. Therefore, the divorce lawyer must negotiate to best protect the 529 funds. This may be relevant in all families, but it is surely critical in the event of divorce.
What else can we do to protect our assets?
Too often a divorcing couple will simply assume the 529 plan funds are non-marital assets. This is another mistake. A well-informed lawyer, divorce master or judge will recognize that the 529 plan account is a marital asset. A parent who deposits funds in a 529 plan account is not removing assets from the marital estate. If a husband and wife want to treat a 529 plan account as nonmarital for the benefit of their children, they must address this by retitling the account or specifying restrictions in the parents’ property settlement agreement. Some suggestions follow:
Split the Plan Between Parents. It is not possible to have joint ownership of a 529 plan account. In some cases, mother and father will roll over half of the funds into a separate account, with each parent having ownership control over half of the assets in the predecessor 529 College savings plan. Each will designate the child as the beneficiary. If there is more than one child, each child’s 529 plan account can be split between the parents. Or the parents may agree to leave the accounts as titled but opt for other protective measures.
Provide Restrictions in an Agreement. The parties’ agreement and the court order confirming those terms can restrict how the 529 plan funds are to be spent. The agreement may provide the age at which the beneficiary becomes the owner (at age 18 or older).
Monitor the Account. The 529 plan account may be structured to authorize agents to have access to account information and statements. Pennsylvania 529 plans allow for interested parties to receive quarterly statements and for both parents to be informed of withdrawals. Parents often agree to share online access and passwords so each can check on the invested funds.
Give Authority to Another Individual. A limited power of attorney can be executed by the owner authorizing a third-party non-owner to act on the account. The power of attorney could provide that the person with the power has responsibility to report on transactions, in advance, to both parents.
Transfer Ownership, Specify Successors. The owner of a Pennsylvania 529 plan can change the owner of the account to the other parent, to the beneficiary (once over 18), or a third party such as a trust. Under the qualified tuition program, the funds can be rolled over to a successor beneficiary. What if the designated primary beneficiary completes school and excess funds remain? The favorable tax treatment will be preserved if distributed funds are rolled over for the benefit of a member of the beneficiary’s family, which would include a sibling, a spouse, a parent, the child of the beneficiary, grandchild, nieces and nephews, first cousins and more. If the parents want to distribute the excess marital funds, they can be withdrawn, taxes and penalty paid, and the excess funds equitably divided as provided in their agreement.
The provisions of the parties’ divorce agreement are valid restrictions on a qualified tuition program for 529 plan accounts. Saying nothing about the 529 plan account in the parties’ agreement or final decree, and assuming the funds belong to the child, is the mistake no family lawyer should make.
So what will happen with the emptied 529 College Savings Plan?
The father in your office, who tells you that the money is gone, may have no recourse under the Divorce Code because the 529 plan account balance was disclosed and there was no fraud committed by the other party. The language of the divorce settlement should have protected the money for the intended outcome: the college education of the parents’ child. If the client, his relatives and other loved ones contributed to a 529 plan account that has been legally emptied by his ex-wife, the lawyer who failed to protect the interests of the father may have disturbed a hornets’ nest and will need to answer to the father and all angry donors.
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