There are two main ways that today’s families save for college costs: one is the 529 savings plan, and the other is through a custodial account, typically an UTMA account (Uniform Transfer to Minors Account.) In the past, clients may have used Uniform Gift to Minors Accounts (UGMAs) but most custodial accounts are now titled as UTMAs, and for all practical purposes, there is little difference. Another vehicle no longer much used is the Coverdell ESA (Education Savings Account) which has a contribution limit of $2,000 per year.
These accounts grow tax-deferred. As long as the money is ultimately withdrawn for qualified expenses at an institute of higher education, which can include vocational schools as well as colleges and universities, there is no tax due on the gains. If the money is not withdrawn for these purposes, there is a 10% penalty and capital gains tax due on the profit in the account. Qualified expenses include tuition, books, computers, and the like. Some states will also provide state tax deductions on state resident contributions to the state 529 plan. Unfortunately California is not one of these states. In any case, the student is under no obligation to attend school in the state of the plan.
The student is the beneficiary of the account, and the owner is the adult who opened the account (typically parent or grandparent). The beneficiary can be changed, so if a parent has two children and two 529 accounts, and one child elects not to go to college, the parent can decide to transfer the unused 529 into the other child’s account with no tax or other ramifications. If there is money left over after college (a problem many of today’s parents would love to have!) the owner can make him or herself the beneficiary of the account and use it for their own education, which could be at a culinary school or golf academy.
Since the 529 account does not belong to the student, assets are weighted less heavily as part of the Expected Family Contribution or EFC for the FAFSA (Free Application for Federal Student Aid), which covers need-based aid. In general, for a dependent student on the FAFSA, all of a student’s assets and income are considered as available for college, while a smaller percentage of the parent’s assets are available.
If a grandparent owns the 529 account, distributions for the student are considered student income on the FAFSA and will increase the EFC. The grandparent can transfer the 529 account to the parent to avoid this if the plan allows, or distribute the money for the last year of college, after the final FAFSA has been completed. Transferring the 529 account to the parent will make it includible on the FAFSA as a parental asset.
Once the minor is of age (18, 19 or 21 depending on the statute) the account is transferred to the beneficiary, and the original custodian has no control over the money going forward.
Custodial accounts are counted as student assets, so they will increase the Expected Family Contribution on the FAFSA compared to a parent or grandparent owned account such as a 529. However, UTMA/UGMA accounts are more flexible in terms of what the money can be used for compared to a 529.