A custodial account is a savings accounts established for a child under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). A custodian, typically a parent or grandparent, controls the account and makes all investment decisions until the beneficiary reaches legal age. Once the beneficiary is an adult and has legal control of the account, they are free to use the funds however they want.
Custodial accounts may be set up through a financial institution, such as a bank, mutual fund company or brokerage. Families saving for college may set up a custodial 529 plan account. A custodial 529 plan account is a 529 plan owned by a minor child, who is also the named beneficiary on the account. Custodial 529 plan accounts offer many of the same benefits as a traditional 529 plan account, but there are also some important differences.
Custodial 529 plan account versus a traditional 529 plan account
The account owner of a traditional 529 plan account retains control of the funds throughout the life of the account. The beneficiary has no legal rights to the account, and the account owner may withdraw the funds or change the beneficiary to a qualifying family member at any time.
With a custodial 529 plan account, however, the beneficiary gains full control of the account once they reach legal age. Up until that time, the account must be managed for the benefit of the child. The custodian must not withdraw funds for a purpose other than to pay for the child’s education, and they typically cannot change the beneficiary.
Financial aid treatment
Assets in a traditional 529 plan account (owned by a parent or dependent student) and assets in a custodial 529 plan account are treated as parental assets on the Free Application for Federal Student Aid (FAFSA). A maximum of 5.64% of parental assets are counted in a student’s Expected Family Contribution (EFC), compared to 20% of student assets.
Generally, a parent’s reportable 529 plan assets includes the value of the child’s 529 plan and parent-owned 529 plans established for their siblings. However, if the sibling’s 529 plan is a custodial 529 plan, it is not reported on the FAFSA, since the sibling (not the parent) is the account owner.
Reasons to consider a custodial 529 plan account
There are several reasons to consider opening a custodial 529 plan account instead of a traditional 529 plan account.
- Grandparents may want to open a custodial 529 plan account for a grandchild, rather than opening a traditional 529 plan account that is owned by the grandparent. The grandparent can retain control over the account by serving as custodian until the grandchild reaches the age of majority. Distributions from a grandparent-owned 529 plan may hurt a student’s eligibility for need-based federal financial aid, but distributions from a custodial 529 plan account are not reported on the FAFSA.
- Grandparents may be concerned about a parent taking non-qualified distributions from a parent-owned 529 plan account to pay for living expenses or extravagances.
- Grandparents may want to keep the 529 plan secret from the family until the grandchild is ready to apply for college admission. Since there is no annual tax reporting on a 529 plan account, nobody needs to know about the account until the grandparents are ready to announce their surprise.
- Parents who started saving for college in a custodial account may convert the account to a custodial 529 plan account to take advantage of tax benefits and favorable financial aid treatment.
Converting a custodial account to a custodial 529 plan account
Potential Tax Savings
There may be tax advantages to converting a child’s custodial account to a custodial 529 plan. In a 529 plan, investment earnings grow tax-free and are not taxed when the funds are withdrawn to pay for qualified education expenses. But, investment earnings in a custodial account are subject to the Kiddie Tax, which applies to minors under age 19 or full-time college students under age 24.
Under Kiddie Tax rules, the first $1,050 of a child’s unearned income is tax-free, and the next $1,050 is subject to the child’s tax rate. Any additional earnings above $2,100 are taxed at the rates that apply to trusts and estates, which range from 10% to 37%, based on the amount of unearned income.
Note, however, that liquidating mutual funds in a custodial brokerage account may trigger capital gains, which are reported on the child’s tax return.
Financial aid impact
When college savings are held in a custodial account, up to 20% of the value of the account is added to the student’s EFC. For example, $10,000 saved in a custodial bank account would be counted as $2,000 in available funds to pay for college.
If the funds are converted to a custodial 529 plan account, the assets are treated as a parental asset on the FAFSA and counted at a maximum of 5.64% of the account’s value. $10,000 saved in a custodial 529 plan account will reduce eligibility for need-based financial aid by at most $564 in available funds to pay for college.