Impact of a Gift Trust Account on Eligibility for Need-Based Financial Aid

Impact of a Gift Trust Account on Eligibility for Need-Based Financial Aid

My daughter turned 18 recently, and received a $25,000 mutual fund

statement with her name on it. Her aunt had put $10,000 away in 1995

in a gift trust account for a minor. This was a mutual fund account in

which the interest was reinvested each year and therefore no IRS

interest statements were generated. We were unaware that her aunt had

opened this account and let the money grow for 17 years. My daughter

will be applying for financial aid for her sophomore year in college

and must fill out the FAFSA and CSS Financial Aid PROFILE forms. How

will this $25,000 mutual fund affect her financial aid for next year?

She does not have any assets and works a part time job for income.

What is the smart thing to do in reducing the affect of this asset for

financial aid? Can she put the mutual fund in my name? I do not not

own a home due to a recent foreclosure and do not have much assets.

— A.K.C.

A gift trust account is an irrevocable trust fund. It is structured so

that the amount contributed to the trust by the trust’s creator is

not subject to gift or estate taxes. To qualify, the gift must be

irrevocable, meaning that the creator cannot change his or her mind

about the gift or change the beneficiaries. The amount contributed

must fall under the annual gift tax exclusion at the time of

contribution. The trust terminates at a future date or when conditions

specified in the trust document are satisfied, such as when the

beneficiary reaches the age of majority, at which time the beneficiary

will receive the gift trust account.

In addition, the contributions to the gift trust account must

represent a present interest to the beneficiary, not a

future interest. This means that the beneficiary must have

been able to withdraw the funds from the account. As with a Crummey

trust, the beneficiary should have been informed about the

contribution to the trust at the time of the gift and then had the

opportunity to withdraw funds for a limited period of time, typically

30 days.

But since the beneficiary was a minor at the time, the minor’s

interest in the gift trust account would have been structured as a

custodial account. The notice of the gift would have been provided to

a custodian on behalf of the minor. It is likely that the creator of

the trust also served as the custodian.

This is a clever way of giving money to a minor in a tax-advantaged

manner that precludes the child’s parents from having access to the

funds. It also protects the money from the parent’s creditors.

If the student and parents are unaware of the existence of a gift

trust account, they have no obligation to report it as an asset on the

Free Application for Federal Student Aid (FAFSA) or other financial

aid forms. So the failure to report the gift trust account as an asset

during the student’s freshman year, before she reached the age of

majority, does not present a problem.

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.

Source: Fastweb

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