06 Dec How does the FAFSA treat a custodial account?

Q. If a grandparent has a custodial account for a grandchild, does that affect financial aid?
— Grandparent

A. Yes, a custodial account will impact financial aid.

The funds in a custodial account are treated as an asset of the child regardless of who the custodian is, said Lisa McKnight, a certified financial planner with Lassus Wherley, a subsidiary of Peapack-Gladstone Bank, in New Providence.

As a result, financial aid eligibility will be reduced by 20% of the funds in the account, McKnight said.

“A good rule of thumb is to follow the taxes,” she said. “If the child reports the interest and dividends on his income tax return, the child is the account owner.”

McKnight said if you knowingly fail to report the account, the penalties include monetary fines and even imprisonment. Because the bank issues a 1099-INT to the child for the interest earned by the account, your failure to report will be considered willful, she said.

“One solution to the custodial account is to spend down the balance in the account to pay for the student’s college education,” McKnight said. “This will reduce the impact of the account on eligibility for need-based financial aid next year.”

The family should spend the student’s assets to pay for the student’s education before using any parent assets, she said.

Another solution is to roll the money into a custodial 529 college savings plan.

McKnight said a custodial 529 plan is titled the same as the original account that was used to fund the 529 plan.

“Even though the student is the account owner of a custodial 529 plan, federal law treats the account as an asset of the parent on the FAFSA,” she said. “Parent assets are counted at 2.6% to 5.6% versus 20% for the student. This results in a much more favorable treatment on the FAFSA.”

Note that while non-custodial 529 college savings plans owned by a grandparent is not reported on the beneficiary’s FAFSA if the beneficiary is a dependent student, grandparent-owned 529 plans are reported on the CSS Profile.

“It is important to note that if a 529 plan is not reported as an asset on the FAFSA, any distributions from the 529 plan must be reported as untaxed income to the beneficiary on the subsequent year’s FAFSA,” she said. “Student income is counted at 50%, which can have a detrimental effect on financial aid.”

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This story was originally published on Dec. 6, 2019.

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