Students whose parents are divorced have some planning opportunities if the exes are willing to cooperate. The first step is of course to understand the planning areas. And the first step of that first step is to understand a key definition: “custodial parent.”
Custodial parent is used in two primary places for college purposes, and in ways that are completely separate from the custody arrangements in the divorce decree:
- On the FAFSA, the custodial parent is the parent with whom the student spent the most time in the previous year. It has nothing to do with who claimed the student on their taxes or what the divorce decree says. Even in cases of joint custody, there are 365 days in most years which means that one parent had the student more than the other did. The FAFSA does not request a sleep log or anything of that sort; rather, the custodial parent needs to be able to be reasonably seen as the custodial parent. That means, for example, that they live in or near the student’s school district.
- For tax credit purposes, such as the American Opportunity Tax Credit or Lifetime Learning Credit, only the parent claiming the student on their tax return can claim an education tax credit.
The FAFSA is the obvious planning opportunity. On the FAFSA, only the custodial parent reports their income and assets. Generally it’s best to have the lower-earning parent complete the FAFSA, as long as they can make the case that they are the custodial parent. Often, however, exes with unequal incomes still come out with fairly similar EFCs from the FAFSA. That’s because untaxed income like alimony or child support is reported by the receiving parent and subtracted by the paying parent. Adjustments to payment schedules, frontloading support payments, and other strategies can be helpful in reducing EFC by minimizing this income in FAFSA years, if the exes cooperate.
Remember, too, that since the noncustodial parent’s income and assets are not reported on the FAFSA, any contributions they make to college costs are counted as student income. So if mom is the custodial parent and dad has a 529 for the student, the student should wait until January of sophomore year in college to withdraw from dad’s 529 in order to not report the distribution on the FAFSA. One strategy to mitigate this is for dad (in this case) to make a contribution to a 529 owned by mom after the FAFSA is filed, and then use that contribution to fund college. Again, cooperation between the exes is essential.
What about a new spouse? If the custodial parent has remarried, then the new spouse’s income and assets are also reported on the FAFSA. The Profile will collect information from both parents, including new spouses of either or both.
The American Opportunity Tax Credit is the free money opportunity, so it deserves some attention. The AOTC is a tax credit of up to $2,500 for the parent of a college student. With the tax law changes that went into effect in 2018, dependent students over age 17 are less beneficial for tax purposes, getting only a $500 tax credit for the parent. Previously, the dependent exemption was a deduction, which is more valuable to the parent in the higher tax bracket; the credit is the same amount regardless of income. The AOTC is only available to single or head of household filers with AGI below $80,000. In the case of a divorce when one parent is eligible for the AOTC and the other is not, having the eligible parent claim the student during the college years can yield $10,000 in tax savings over four years, which could be used to cover college costs.
One key element to planning is that the dependent or custodial status can be treated separately for each aspect– the divorce itself, the FAFSA and tax filing. Just because one parent claims the student on the FAFSA, does not mean that they have to claim them on their taxes. Exes who are willing to work together can save substantial sums on college by using the system to their advantage. To summarize:
- The custodial parent on the FAFSA is the one with whom the student spends the most time.
- Only the parent claiming the student on their tax return is eligible for the AOTC.
- Divorced parents who remarry must report the new spouse’s income and assets on the FAFSA.
- The CSS Profile requires financial information from both parents.
- Contributions to college from the non-custodial parent are treated the same as any non-parental contributions. 529 distributions or direct payments of tuition are student income and thus should be avoided or limited until January of sophomore year.
There is one area that’s very confusing: when one parent completes the FAFSA and the other wants to take out Parent PLUS loans to cover their share of college costs. The FAFSA is the ticket to federal student loans. However, this does not mean that both parents would need to complete the FAFSA. Rather, the non-custodial parent would simply work directly with the school to take out the loan.