How will my son’s inheritance impact financial aid?

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Q. My mom passed away last year and left money in an irrevocable trust for my boys, one of whom is going to a very expensive university. The timing was after filing the FAFSA, but I need to straighten things out before filing this year. I want to put the money in a 529 plan so its assessed at the lower rate for financial aid purposes. And what happens if he gets scholarships?
— Parent

A. We’re sorry to hear about your mother.

Your description of the trust is important here because we’re not clear if there was one trust with multiple beneficiaries or separate trusts for each of your kids.

But we can address the 529 plan part of your question.

First, you’re correct that money placed in a 529 plan would be assessed at 5.64 percent versus the 20 percent rate for the student’s assets.

Most trusts don’t protect assets from the financial aid process, said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway.

“Even if the creator of the trust placed restrictions on access to the trust by the beneficiary, such restrictions are considered voluntary,” he said. “The only exception is when the restrictions on access to the trust are involuntary, such as a trust that is restricted by court order.”

McCarthy said determining who should report the trust fund as an asset is often straightforward:

  • If the trust fund is in the name of the student, spouse, or parent, then it should be reported as that person’s asset on the FAFSA.
  • If the trustee has the authority to change the beneficiary, then the trust may be reported as an asset of the trustee.
  • If a trust is dedicated to paying for the beneficiary’s education, it should be reported as an asset of the beneficiary.
  • If a trust does not pay its own taxes, follow the money. The individual who pays taxes on the trust’s income is often the owner of the trust.
  • If the trust is owned by more than one individual, each owner reports only the part he or she owns. If the trust does not specify the percentage ownership of each individual, then ownership is divided equally by the number of owners.

McCarthy said some trusts assign ownership of the income and assets to different individuals.

“In that case, the value of the ownership rights is more complicated requiring a rather detailed analysis of the trust document,” he said. “This generally means the value of the trust allocated to your son – not the whole trust – needs to be reported as an asset on the FAFSA and CSS as a student asset.”

As such it will count at 20 percent per year in the calculations, he said.

The good news is that – generally – 529 plans can be held by a trust because 529 plans meet the standard prudent investor rule applicable to trusts, he said.

“There are nuances and legal considerations with any transfer of a trust into a 529 plan, so it is important that you speak with legal counsel when employing this strategy,” he said. “Make sure the terms of your trust allow you to invest inside of a 529 plan.”

He said the rules of the trust always apply. 529 accounts can accept only cash, so trust assets not held in cash must be sold to affect a transfer, which can create a taxable event, McCarthy said. This is another consideration that should be discussed with your tax advisor.

He said the trust should be named as the participant of the 529 plan and the child as the beneficiary.

“Trusts with multiple beneficiaries will have to open separate 529 accounts for each one, if necessary,” McCarthy said. “Indicate on your account application that this is a transfer from a trust. You must submit a certified trust document with your account application, which the 529 custodian will hold on file.”

He said moving money from an irrevocable trust to a 529 plan will have the impact of changing those dollars from a student-owned asset to a trust-owned asset, lowering its impact on the financial calculation to up to 5.64 percent.

It also allows you to change the 529 beneficiary to a sibling down the road.

McCarthy said you can use the 529 to pay for any school costs above any scholarships received. These would be considered “qualified” distributions and as such tax-free.

However, if the student gets a full scholarship, any withdrawals from the 529 would then be considered non-qualified withdrawals subject to a 10 percent penalty and income tax on the earnings portion of the distribution. There is an exemption to the 10 percent penalty for any non-qualified withdrawals up to the amount of the scholarship, he said.

“The return of your principal in the 529 is tax-free as you already paid taxes on that money before contributing to the 529,” he said. “Keep in mind that taxes will still have to be paid on the earnings part of the withdrawal.”

You should meet with an advisor who is knowledgeable about trusts and college financial aid to make sure you make the right moves here.

For help with the FAFSA, don’t miss this story.

Email your questions to moc.p1563743516leHye1563743516noMJN1563743516@ksA1563743516.

This story was originally published on May 1, 2019.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.