There are several reasons why a family might create a custodial 529 plan account instead of using a regular 529 plan account. For example, a contributor may want to retain control over the 529 plan account without hurting the student’s eligibility for need-based financial aid. The contributor may wish to keep the 529 plan secret from the rest of the family. The contribution may have come from an UGMA or UTMA account.

Retaining Control over the 529 Plan Account

Sometimes, a relative may want to retain control over the 529 plan account without being the account owner.

For example, a grandparent, aunt or uncle might be unwilling to contribute to a parent-owned 529 plan because of concerns about how the money might be used. They might be worried that a spendthrift parent will take a non-qualified distribution to buy a big-screen TV or Porsche. More realistically, a parent who is experiencing financial difficulty might use the 529 plan money to pay for groceries.

When the parents are divorced, one parent might fear that the other parent will liquidate the account or refuse to use it to pay for college costs. There might be a disagreement about whether the 529 plan account counts as part of which parent’s college support obligation. If the account is owned by the non-custodial parent, it can hurt the student’s financial aid eligibility. One parent might worry that the account owner will remarry and change the beneficiary to a stepchild.

Retaining control over the 529 plan account ensures that the money is used for its intended purpose.

But, if anyone other than the student or the student’s parent owns the account, it can have a negative impact on the student’s eligibility for need-based financial aid. So, serving as the account owner is not always an ideal solution.

Instead, a custodial 529 plan account can solve these problems. The beneficiary of a custodial 529 plan account cannot be changed. The contributor can serve as custodian, retaining control over the account until the beneficiary reaches the age of majority. Since the 529 plan account is owned by the student, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA), thereby yielding a minimal impact on the student’s financial aid eligibility.

Money Came from a Custodial Bank or Brokerage Account

If the funds for a 529 plan account came from a custodial bank or brokerage account (e.g., a Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account), the funds must be contributed to a custodial 529 plan account. The custodial 529 plan account must be titled the same as the original custodial account and will still be governed by the UGMA/UTMA provisions.

It is not uncommon for families to rollover a custodial bank or brokerage account into a custodial 529 plan account because a 529 plan account has a more favorable impact on the student’s eligibility for need-based financial aid. Money in a custodial bank or brokerage account will be reported as a student asset on the FAFSA, which reduces aid eligibility by 20% of the asset value. This is in contrast with money in a custodial 529 plan account, which reduces aid eligibility by at most 5.64% of the asset value.

Money in a 529 plan account also has a superior tax treatment as compared with money in a custodial bank or brokerage account. UGMA and UTMA accounts have a favorable tax treatment, but only up to a point. Under the Kiddie Tax in 2020, the first $1,100 in unearned income is tax-free and the second $1,100 is tax at the child’s tax rate. Unearned income over $2,200 is taxed at the parent’s rate. This contrasts with money in a 529 plan, which can be entirely tax-free.

529 plans also provide age-based investment options, which are generally not available on custodial bank and brokerage accounts. 529 plans also have tax-advantaged gifting options, such as five-year gift tax averaging.

Keeping the 529 Plan Account a Secret

Another reason to set up a custodial 529 plan account is to keep the money secret from the family. If a grandparent, aunt or uncle were to contribute to a parent-owned 529 plan account, the parent would learn about the contribution.

But, if you know the child’s date of birth, full legal name and Social Security Number (or Individual Taxpayer Identification Number), you can create a custodial 529 plan account for the child.

Since there is no annual tax reporting for a 529 plan account with no distributions, you can keep the custodial 529 plan account secret from the rest of the family. This lets you plan a big surprise when the grandchild is ready to choose a college.

Also, if the student and parents are not aware of the existence of the custodial 529 plan, they are not required to report it as an asset on the FAFSA.

Financial Aid Impact of the 529 Plan

Although a custodial 529 plan account and a parent-owned 529 plan account have the same impact on the student’s eligibility for need-based financial aid, there is a difference that affects the financial aid eligibility of the student’s siblings.

A custodial 529 plan is not reported as an asset on the FAFSA of the beneficiary’s sibling, while a parent-owned 529 plan is reported as a parent asset on the FAFSA. Thus, a custodial 529 plan will affect the financial aid eligibility of the beneficiary, but not the beneficiary’s siblings. In contrast, a parent-owned 529 plan will affect the financial aid eligibility of the beneficiary and the beneficiary’s siblings.

Thus, one strategy for partially sheltering assets is to save them in a custodial 529 plan. Such a 529 plan is reported as an asset on just the beneficiary’s FAFSA. There is limited utility to this strategy, since the custodial 529 plan is legally the property of the beneficiary and the earnings portion of a non-qualified distribution will be subject to income tax plus a 10% tax penalty. Nevertheless, some people create custodial 529 plan accounts to reduce the impact on financial aid eligibility for the beneficiary’s siblings.