By: Joseph Goldy, CFP®
College planning is a common financial goal for many households. However, for newly independent women going through a divorce, paying particular attention to how the term “custodial” is used in the divorce agreement is essential since it can impact the calculation for college financial aid.
The FAFSA and Income
The Free Application for Federal Student Aid, also known as FAFSA, is the form used by the Federal Student Aid office of the U.S. Department of Education to gather necessary data on college-bound students. Colleges then review the information on the FAFSA, such as income from students and parents, to determine the amount of financial aid a student may receive.
How Custodial Parent Designation Impacts Financial Aid
For awarding financial aid, an important consideration is how the term “custodial” is defined since it is the custodial parent’s financials used to determine how much help a student may qualify for. In this context, FAFSA defines a custodial parent as the parent the child spends most of the time with throughout the year. This definition presents a planning opportunity for newly independent women who may still be going through a divorce.
In cases where there is a significant income discrepancy between parents separating, having the lower-income parent be listed as the custodial parent could make sense to provide a more favorable aid package based on the lower income.
Although the FAFSA form is undergoing changes beginning with the 2022/23 school, currently, about 22% to 47% of a parent’s income is used in the calculation of aid, with a more significant share being counted for higher-income parents.
For divorcing people still in the process of drafting their agreement, it could be a smart planning move to have the lower-income parent listed as the custodial parent.
One caveat, this planning technique would only apply to the FAFSA form and not the CSS form, which some smaller private schools require. The CSS requires both parents’ income regardless of the custodial parent. It is also a good idea to check with your tax professional to be aware of any tax implications of a strategy.
529 Plan Divorce Planning
529 plans are the primary vehicle for parents and grandparents to help save for college. They offer benefits such as tax-deferred growth, high contribution limits, and tax-free withdrawals, provided the funds are used for educational expenses. The recent change allowing up to $10,000 of 529 funds to be used for elementary, middle, or high school expenses has only increased their popularity.
However, a common pitfall of 529 plans for divorced parents of college-bound children is inadvertently listing the non-custodial parent as the owner. Once again, which parent has been deemed the “custodial” parent is critical, and the reason lies in the way assets and income are viewed by FAFSA.
How 529 Planning is Impacted by Custodial Parent Designation
If a non-custodial parent (or grandparent) owns the 529 plan, any assets in the plan are disregarded for aid purposes.
At first glance, that sounds like a benefit. Unfortunately, any distributions from the plan are then considered income to the student and will reduce potential aid by a hefty 50% due to how FAFSA factors income. This rule provides a significant incentive to keep assets out of the non-custodial parent’s name.
If assets are currently in a non-custodial parent-owned 529 plan, ensuring the distributions are taken during the student’s junior and senior years will avoid the income being counted in the aid calculation due to a 2-year lookback period.
Combing 529 Plans
Another strategy outlined in an article by Kathryn Flynn on Savingforcollege.com is to time rollovers from a non-custodial or grandparent-owned 529 into a parent-owned plan. If funds are rolled over after the current year’s FAFSA has been completed and then spent before the following year’s FAFSA form is filled out, they will not appear as an asset and thus avoid reducing aid. Kathryn notes that the non-custodial/grandparent-owned plan is the same as the parent-owned one to avoid recapturing the rules of some plans.
To avoid this situation, putting the 529 plan assets in the custodial parent’s name from the start will ensure that the distributions are not regarded as income. To be sure, the plan assets will count toward reducing aid by 5.64%, still much more favorable than the 50% reduction in aid noted above. For example, a $50,000 529 distribution from a custodial parent-owned plan reduces aid by $2,820 vs $25,000 if done from a non-custodial parent-owned plan.
Although this is a current planning concern, as previously mentioned, it may become moot since the FAFSA is changing over the coming years.
One of those changes is how distributions from a 529 plan are characterized in the aid calculation. Under the proposed rules, any distributions from non-custodial or grandparent-owned 529 plans would no longer be used in the FAFSA income calculation for students. Highland is monitoring these proposed changes and their impact on our clients’ education planning.
With careful planning and a thorough understanding of the rules around financial aid, newly independent parents can take advantage of education planning opportunities to ensure their children have the best chance of a generous aid package.
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.