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529 Plans: Fun(d) Facts for Family Lawyers!

Donna Pironti, CPA, MSA, and CFF


  • The Tax Cuts and Jobs Act expanded the qualified expenses allowable by the IRS and the Setting Every Community Up for Retirement Act made further changes to the definition.
  • A 529 account can be set up as a prepaid tuition or college savings plan and involves a beneficiary and custodian.
  • Qualified expenses include tuition and fees, books and materials, room and board, computers, and related equipment for students attending a college, university, or other eligible post-secondary educational institution.
  • Frequent issues raised in a divorce are who is the custodian, contributions, distributions, and financial aid.
529 Plans: Fun(d) Facts for Family Lawyers!
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529 plans are terrific vehicles for saving for a child’s education, but there are some facts that should be considered by all matrimonial lawyers when dealing with these assets in divorce.  This article will cover some history of 529 plans, how to set up an account, tax and other issues related to account contributions and distributions, and specific divorce considerations.

As many of you know, 529 plans, a tax-advantaged savings plan, were originally designed to be used for higher education expenses.  The first prepaid college savings fund was established by the State of Michigan in 1986.  Ten years later, in 1996, after the Michigan Education Prepaid Tuition Plan won a lawsuit against the IRS, Congress enacted Section 529 of the Internal Revenue Code, establishing federal tax rules for 529 plans.  But it wasn’t until 2011, with the enactment of the Economic Growth and Tax Relief Reconciliation Act, which made earnings in 529 plans completely tax free when used for college, that these plans really started to become popular.   Today almost every state has a 529 plan, but not all states allow a tax deduction, and in most states that do allow the deduction, the contribution needs to be made by December 31. 

In December 2017 the Tax Cuts and Jobs Act (TCJA) expanded the qualified expenses allowable by the IRS under 529 plans.  In addition, in December 2019 the Setting Every Community Up for Retirement (SECURE) Act made further changes to the definition.   Both of these Act’s changes to the definition will be discussed below. 

Setting Up A 529 Plan Account

A 529 account can be set up as either a prepaid tuition or college savings plan. A prepaid tuition plan allows in-state public college education to be prepaid, partially or completely, with after-tax contributions.  The fund increases based on post-secondary college increases for the in-school rate you choose.  If a private or out-of-state school is later attended, these funds may be converted to a dollar value and then used. A college savings plans work much like a Roth 401(k) or Roth IRA.  To fund a college savings plan, after-tax contributions are placed in mutual-fund-type investments and then increased or decreased, based on the performance of the funds.    

Custodian and Beneficiary

There are two parties involved with a 529 account – a beneficiary and a custodian (not to be confused with the custodial parent).  The beneficiary is the person whose future education expenses may be paid from the account.  The beneficiary has no managerial authority over the account, except under two exceptions.  The first is when the beneficiary is also the account owner. The second is when the plan allows the custodian to bestow authority on the beneficiary through something similar to a power of attorney on the account.  There are downsides to having one person be both the account owner and the beneficiary: the parent loses control of the money,  account ownership counts against the child in financial aid formulas, the person who owns the account gets to take the state-tax deduction, and most plans require the owner to be at least 18 years old to open an account.  You would really have to trust the child to take only the funds that would allow him or her to qualify for tax-free treatment and not to abuse the account rules.  A beneficiary can be changed at any time, as long as the new beneficiary is a member of the original beneficiary’s family. Qualified family members include the beneficiary’s siblings, parents, children, first cousins, nieces, and nephews. 

Once you have decided which beneficiary you are opening the account for, you need to choose custodian who is the account owner.  When deciding who the account owner should be you need to consider the successor custodian as well. Often one parent is the custodian, and the other parent will take over if something happens to the first parent.   The owner of the account, not the beneficiary, controls the funds until they are withdrawn.  The owner can change the beneficiary and may withdraw funds at any time.  The custodian primarily makes contributions to the account, but anyone can contribute to an already established account.  Under most plans the custodian can be changed, but a state may recapture the deduction benefits if that state permits only the owner of the account to receive the tax benefits for contributions. 

Generally, if a 529 plan is owned by a dependent student or the dependent student’s custodial parent, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA), but distributions are ignored, so the plan funds are an asset, not income.  For those of you who did not apply for financial aid or don’t have kids that do, a FAFSA form is required by most if not all schools to get any kind of need-based aid.  This form basically digs into all the financial information of the dependent student and the dependent student’s parents (or custodial parent).  If the 529 plan is owned by the independent student (as owner and beneficiary) then the student reports the asset, not income, on the FAFSA. 

But if the 529 plan is owned by someone else, such as a grandparent or a non-custodial parent, it is not reported as an asset on the FAFSA, and the distributions count as untaxed income to the beneficiary when the aid is calculated. This is similar to how a gift provided by a grandparent that is paying the tuition is treated – any outside income is supposed to be reported on the FAFSA.  For more on the financial aid and the differences between assets and income for aid, look at the FAFSA form. If you don’t expect your child to need (or qualify for) any financial aid, then the owner of the account does not need to be considered for that purpose, and a parent is likely the best account owner. 

Contributions, Distributions, and the Related Taxes

The whole idea of a 529 plan is for you and your relatives to save for your children’s education, using tax-effective dollars.  Therefore, the tax consequences of contributions and distributions are important. 


You make contributions to your plan using after-tax dollars, although some states allow you to deduct these contributions making them pre-tax for state purposes, as most 529 plans are sponsored by states. Any earnings are tax-deferred while invested, and the withdrawals are then tax free if used for qualified expenses. 

Contributions are to be created to provide for the qualified educational expenses of the beneficiary.  There are no age limits or income phase-outs on contributions, so anyone can contribute to a 529 plan.  There is also no limit to the number of plans you can set up.  There are potential gift-tax consequences, because any one individual can contribute or gift to one beneficiary only up to $15,000 in 2019 (two parents can contribute a total of $30,000 each year). However, there is an exception to the $15,000 limitation.  If in a year you make a contribution between $15,000 and $75,000 for a beneficiary you can elect to treat the contribution as made over a five calendar-year period for gift-tax purposes. This allows you to use as much as $75,000 in annual exclusions to shelter a larger contribution. The money (and the growth of your account) is then available sooner and can grow over a longer period. 

Distributions and Qualified Expenses

As mentioned above, the funds in a 529 plan account belong to the owner of the account, and a withdrawal can be made for any purpose.  Distributions can be made directly to the account holder, beneficiary, or school.  Some accounts also allow you to make payments to third parties, such as landlords, but you need to check with the plan to see how to take these kinds of distributions.  Qualified expenses (discussed below) are 100% tax free if they are for the beneficiary listed on the account.  A Form 1099-Q (Payments from Qualified Education Programs) is issued to the beneficiary if the payment is made to the beneficiary or to the educational institution. If the payments are made to anyone else, the 1099-Q is sent to the account owner.  The amount on the 1099-Q is reported on the recipient’s tax return and then can be offset with qualified educational expenses allowing the distributions to be tax free.  

However, for any nonqualified distributions, there are both federal and state tax consequences.  States can impose a tax on withdrawals equal to the amount of the deductions previously allowed at the time of contributions and any earnings and assess penalties.  On the federal level, the earnings portion of a non-qualified distribution will be subject to ordinary income taxes (which depends on what tax bracket the recipient is in) and a 10% tax penalty, though there are exceptions for the penalty.  The penalty is waived on withdrawals if the beneficiary dies, becomes disabled, or receives a tax-free scholarship, or the qualified education expenses were instead used on the return to generate the American Opportunity Tax Credit or Lifetime Learning Credit. (These credits are a good way to maximum tax benefits when preparing a tax return, particularly for an individual who is independent, but you should discuss the issue with your tax advisor, as there are limits and phase-outs).  However, even though the penalty is waived, your earnings will be subject to federal, and sometimes state, income tax. If you want to avoid paying taxes and a penalty on your earnings, you have a few options, including changing the beneficiary to another qualifying member, holding the funds in case the beneficiary wants to attend graduate school later, or make yourself the beneficiary and further your own education. 

At the post-secondary level, a general rule of thumb is that expenses required for enrollment in an eligible institution are covered. Qualified expenses include tuition and fees, books and materials, room and board (for students enrolled at least half-time), computers and related equipment, internet access, and special needs equipment for students attending a college, university or other eligible post-secondary educational institution. For on-campus residents, qualified room and board expenses cannot exceed the amount charged by the college.  For students living off campus, rent can be covered, but qualified room and board expenses are limited to the “cost of attendance” figures provided by the college. Transportation costs, health insurance, and student loan repayments are not considered qualified expenses. As mentioned, TCJA changes in the tax code now allow distributions of up to $10,000 per year, per beneficiary, to pay for kindergarten through grade 12 tuition.  Many, but not all, states follow the federal tax code as some states may not consider K-12 tuition a qualified educational expense  The SECURE Act further expands “qualified higher education expense” to include amounts paid as principal or interest on any qualified education loan (as defined in IRC Sec. 221(d)) of the designated beneficiary or a sibling of the designated beneficiary.  In addition, it expands “qualified higher education expense” to include expenses for fees, books, supplies, and equipment required for the participation of a designated beneficiary in an apprenticeship program registered and certified with the Secretary of Labor under section 1 of the National Apprenticeship Act.  Note that homeschooling expenses are still not covered.

For all of those parents who had children in college during the Corona Virus pandemic, many of you received a refund (although likely not as much as you would like) of room and board fees.  If you paid for these fees with 529 plan funds, these funds are taxable to you unless you do one of the following:

  1. You can put the money back in the 529 plan within 60 days of receipt of the funds. Each 529 plan tracks this differently, so you should call your plan administrator to ensure you put the funds back properly. 
  2.  Hold the money and use it to pay tuition in the fall for the same individual (it must be used in the same year it was taken out). 
  3. You can go back through your receipts and see if there was anything you paid out of pocket that meets the rules of use of the funds.  This last one is particularly important for those that graduated this semester and do not plan to go to graduate school or take any additional classes this year. 
  4. You could pay student loans for the beneficiary or the sibling if they are outstanding.

Divorce-Specific Issues

The most frequent issues I see related to divorce are related to who is the custodian, contributions, distributions, and financial aid. 

Often during and after divorce, the custodian issue is raised.  One party may have concerns over how the funds are used. One parent may want to have someone other than their soon-to-be ex-spouse control the account, so they do not have to worry about misuse of the funds or having to deal with the ex-spouse in order to get the tuition paid.  A separate custodian that both parties trust could be appointed.  However, understand that the custodian then owns the account.  Some plans may allow for the account to be divided and each parent then has control over a portion of the account.  In addition, any financial aid issues may come to light if one party is the owner of the account but not the custodial parent, or vice versa.  Regardless, how the accounts are held should be addressed in any agreements. 

As you all know, for divorce purposes, some states do not require parents to pay a dependent’s college expenses.  Therefore, contributions to a 529 plan are not required post-divorce.  In many circumstances, however, an agreement is made regarding how much each party will contribute to the fund.  Each states rules and the plan needs to be looked at to determine the limitations per child so that the parents  each receive the state-tax deduction for the contribution.  If an agreement as to how college will be paid for can be made at the time of divorce, it would be beneficial to do so then, rather than waiting until the child is about to attend college. 

This new addition of the allowance for K-12 tuition may cause a depletion of funds that were intended for college expenses.  If a child is attending a private K-12 school, the parties should consider whether this can continue under the circumstances and how it should be funded.  This is of particular concern since for states that do not require a parent to pay a dependent’s college expenses.  The agreement needs to state how funds should be used, so that the parent that is not the account owner is not surprised when the child heads off to college. 

As always, it is a good idea to have your client consult their financial advisor and CPA on what plan they have and how best to keep the funds intact going forward.