Divorce is a difficult and stressful process for anyone to go through. And when it involves children, a level of complication is added into the fold. There are weighty matters of finance to be discussed, including the question of who will pay for the children's college education.
With enough planning and foresight, there are ways in which all parties can emerge from divorce in better financial shape and without some of the avoidable psychological scars. Controlling your emotions can be just as important as understanding the nuances of financing and tax law, all of which can help ensure your child's college tuition stays on track during the divorce process.
Communication is key
“Divorce is a highly emotional period in people's lives," says Cyndy Ranzau, a wealth strategist with RBC Wealth Management-U.S. "It has a tendency to cause parents to behave in ways they otherwise would not."
For that reason, says Alan Wolberg, a senior wealth planner at City National Bank, the three most important things to remember when going through a divorce are "communicate, communicate, and communicate."
"You have to be logical and not emotional," he adds.
The topic of who pays for a child's college education, and how, needs to be discussed in a "level-headed" manner, Wolberg explains. That can be tricky because financial disagreements often surface due to both parties not being on the same page when it comes to managing family money.
“The first and only thing a divorcing couple needs to know is there has to be an agreement — a stone-cold, non-emotional one — to communicate about the education finances and other things," he says.
Now is the time to start talking rationally, as difficult as that may be.
Who pays and with what?
College is an expense that will impact two other major components in a divorce settlement: spousal support (alimony) and child support, Wolberg explains. If one person is expected to pay the college expenses, that may reduce their other obligations from the divorce. How it impacts those obligations must be reflected in the divorce decree, Wolberg explains, but the decree might not address all potential issues. “The financial portions of divorce decrees are based on formulas, but if you only rely on the formulas you might not be doing things correctly," he says.
As an example of things gone awry, Wolberg points to Jim, a friend going through a divorce who had set aside money for his child's college tuition in a 529 plan, a tax-advantaged savings plan for college expenses.
During the divorce, Jim and his soon-to-be-ex-wife agreed they would split the cost of college equally between them. While that may sound perfect, the reality was more problematic. They'd forgotten something.
Jim's ex-wife got custody of the 529 college savings plan in the divorce, which she then used to pay for her share of the college bills. This meant that Jim, who contributed the entire savings in the 529 plan, in effect paid the entire cost of college. In this case, that wasn't what was meant to happen, Wolberg says, and the couple should have returned to court for a rewritten divorce decree to reflect the fact that one spouse had custody of the 529 plan.
Complexities of a 529 plan
Jim's example points to a sometimes problematic requirement of 529 plans: they cannot have more than one custodian. The custodian will likely be the child's mother or father, but a grandparent may also set up a 529 plan with the grandchildren in mind. Who receives custody of the 529 plan in a divorce is something a judge might miss during the process, which is another reason for both parties to communicate and ensure the outcome they both want is reflected in the settlement documents.
There are other nuances to 529 plans as well. Although these plans were designed as tax-advantaged saving vehicles to help cover education costs, custodians must pay close attention so that otherwise-avoidable tax matters don't arise. For example, if too much cash is withdrawn, taken at the wrong time, or withdrawn for ineligible expenses, your child could receive an unexpected tax bill. The exact size of that tax liability will depend on their combined investment income and earnings. It may be worth consulting a tax specialist on such matters.
Even if your family has the financial means to pay for college, it's still worth exploring a variety of alternatives for how to cover the cost.
For example, some merit-based scholarships are awarded regardless of financial need, something that families may not realize. “Many scholarships do go untapped, unfortunately," Ranzau says. Part of the reason for that, she adds, is the task of researching which awards are available, and who is eligible, can be laborious.
In other words, there is work involved for both parents and children. The process will likely involve your child writing multiple essays, which will be good practice for college.
Some colleges may also match the funds of those independently awarded merit-based scholarships. For example, if your child receives a tuition check for $20,000 for being the best science student in your home state, the university may add an additional $20,000 in the form of tuition reduction. The total can add up quickly.
Other financial considerations
High-net-worth families often ask if they should take time to complete the FAFSA (Free Application for Federal Student Aid) and CSS (College Scholarship Service) documents even if they have the means to pay for the full cost of college. The answer is yes, because to even be considered for college-administered merit-based scholarships, you need to fill out such documents. Without the timely submission of the forms, your child may not even be in the race.
Completing such forms may also open up government student loans, which can provide added financial flexibility. Sometimes family wealth isn't immediately accessible, with money tied up in illiquid assets (it's always worth exploring alternative or temporary ways of managing a portfolio of assets).
The implications of 529 plan ownership will also play an important role as divorced families look to qualify for financial aid, Ranzau explains. For example, only the income and assets of the parent the child has lived with during the prior 12 months is included on the FAFSA, so if one parent earns less than another, more financial aid may be available if the lower-earning spouse is the 529 plan owner.
If the 529 plan is owned by the parent the child does not live with, the 529 assets will not be counted on the FAFSA. However, the withdrawal from the 529 to pay for tuition would be considered income from the 529 and will impact the FAFSA more harshly. The income from the 529 can reduce aid by as much as 50 percent, whereas if the 529 plan was owned by the spouse the child lives with, the assets of the plan only reduce aid by 5.64 percent.
Discussing these issues and the many other complexities of who pays for college and how during a divorce may be stressful. However, all parties can benefit from planning.
"Instead of looking at it as one person coming out ahead, a plan puts both parties in a position to be self-sustaining moving forward," says Ranzau. "Planning eases the impact of dividing one household into two, and should ultimately reduce friction between parents and facilitate a better outcome for children."
City National Bank (CNB) is an affiliate of RBC Wealth Management and an indirect wholly owned subsidiary of Royal Bank of Canada. The report is provided for informational purposes only and is not intended to be either a specific offer by CNB to sell or provide, or a specific invitation to apply for, any particular financial account, product or service of RBC Wealth Management.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.