Impact of a Gift Trust Account on Eligibility for Need-Based Financial Aid
September 10, 2012
But even if the creator of a gift trust account for a minor serves as custodian for a minor beneficiary, it is unclear how the creator would have been able to hide the existence of the trust from the child and the child’s parents. Although trusts can have a separate taxpayer identification number and file their own annual tax returns, in most cases the benficiary must pay income tax on the trust’s annual income. (A major exception occurs when the creator of the trust has a legal obligation to support the beneficiary, in which case the creator of the trust would pay income tax on the trust’s income.) The automatic reinvestment of the interest in the account is irrelevant, as the interest must still be reported as income to the beneficiary.
The most likely scenario is one in which the gift trust account was invested in US savings bonds. US savings bonds are exempt from state and local income tax and the federal income tax obligation may be deferred until the bonds are redeemed or reach maturity. The average annual return for a $10,000 investment worth $25,000 after 17 years is 5.5%, consistent with the rates for savings bonds issued in 1995.
Another scenario could involve having the trust invest in stocks or other securities that do not pay dividends. So long as the investments do not pay dividends, there is no taxable income from the investments. So long as the investments are not sold, there would be no taxable capital gains either.
But once the family becomes aware of the existence of the gift trust account, they must report it as an asset on the FAFSA and other financial aid forms. Since the account is owned by the student, it must be reported as a student asset, reducing need-based aid eligibility by 20% of the asset value. Thus a $25,000 student asset will reduce aid eligibility by $5,000. (The annual income from the account must also be reported as student income, reducing need-based aid eligibility by as much as 50% of the amount of income.)
The simplest solution is for the student to contribute the money to a 529 college savings plan with the student as the account owner and beneficiary. Even though the student is the account owner, a 529 college savings plan owned by a dependent student is reported as a parent asset on the FAFSA. Parent assets have a much more favorable treatment on the FAFSA, reducing aid eligibility by up to 5.64% of the asset value. A portion of parent assets, typically $40,000 to $50,000, are also sheltered by the financial aid formula. Thus a $25,000 parent asset will reduce aid eligibility by at most $1,410, and in many cases by a lower figure.
Another solution is for the student to spend the money on her education or other expenses. This can reduce or eliminate the negative impact of the account on her eligibility for need-based financial aid. Assets are reported based on the account value on the most recent statement received before the FAFSA is filed.
It is unclear whether the student can gift the money to her parents. Legally the account is owned by the student. Before she reaches the age of majority in her state, she lacks the capacity to make such a gift and it would be a breach of the custodian’s fiduciary responsibility to transfer the money. It may also be illegal for the custodian to transfer the money, since the creator of an irrevocable gift trust cannot change the beneficiary. After the student reaches the age of majority, she may still lack the maturity to rationally gift the money to a parent, given her likely lack of financial sophistication and the dependent nature of the relationship between child and parent.