How to Minimize the Impact of a Student's Brokerage Account on Financial Aid

<b>We have an UTMA mutual fund for our son who is a senior in high school (17 years old). It is approximately $19,000 and was intended to help pay for college costs. When we opened it we weren't aware of the impact it could have on financial aid. I realize it's too late to fix anything for his freshman year next year, but will it help him any for his sophomore year if we take it out prior to the end of this tax year? His other school money is in an educational IRA and won't ding him as much. — D.G. Custodial bank and brokerage accounts, such as UTMA and UGMA accounts, are treated as a student asset on the Free Application for Federal Student Aid (FAFSA). This has a more severe impact on eligibility for need-based financial aid than parent assets. Student assets reduce aid eligibility by 20 percent of the asset value. Some parent assets are sheltered from the need analysis formula. The remaining parent assets will reduce aid eligibility according to a bracketed scale, with a top bracket of 5.64 percent. Parents can fix such a situation by moving the student's money into the custodial version of a 529 college savings plan. Even though a custodial 529 plan is technically the student's asset, federal law since 2009 has treated custodial 529 plan accounts as though they were a parent asset on the FAFSA. (Prepaid tuition plans and Coverdell education savings accounts are also treated as parent assets, but are more likely to be affected by contribution limits.) Parents can also spend the student's money for the student's benefit, so long as the expenses are not normally considered parental obligations, such as food, shelter and medical care. For example, if the student will need a car or computer for college, the parent could buy it with the student's money. Parents can also spend the student's money for college costs, such as tuition and fees, room and board, and books and supplies. Since assets are reported on the FAFSA as of the application date, parents can address the harsher treatment of student assets at any time prior to filing the FAFSA, not just before the prior tax year. (Practically speaking, any changes in assets should occur at least a month before filing the FAFSA. During verification, college financial aid administrators may ask for copies of bank and brokerage account statements, especially if the interest and dividend income on the student's income tax return is high compared with the student assets reported on the FAFSA. Accordingly, any changes in the student's assets should occur early enough to be reflected in the most recent statements prior to filing the FAFSA.) However, contributions to a 529 college savings plan must be made with cash, not securities. So to roll a student's brokerage account into a custodial 529 plan account, the parent must first liquidate the brokerage account. If the stocks, bonds or mutual funds held in the brokerage account have appreciated significantly, liquidating the account will result in capital gains. Capital gains are treated as income on the FAFSA. Student income received during the prior tax year will reduce need-based aid eligibility by as much as half of the amount of income. To prevent capital gains from affecting eligibility for need-based financial aid, realize them before October 1 of the junior year in high school. Once the student is a senior in high school, however, there's no room to liquidate the brokerage account without having the capital gains affect aid eligibility on the subsequent year's FAFSA. It then becomes a tradeoff between the treatment of the capital gains as income and the treatment of the account as an asset. The student's need-based financial aid package will be reduced by 20 percent of the asset value each year until the brokerage account is liquidated. If the money is rolled over into a custodial 529 plan account, the financial aid package will be reduced by up to 5.64 percent of the asset value each subsequent year until the money is spent. When the brokerage account is liquidated, the student's need-based financial aid package during the subsequent year will be reduced by up to 50 percent of the capital gains. Regardless of whether the money is spent on the student's college education directly or rolled over into a custodial 529 plan account, the brokerage account must be liquidated. So realizing capital gains is unavoidable. (One could avoid liquidating the brokerage account until after the FAFSA is filed for the student's senior year in college. But then the student's asset will reduce aid eligibility by 20 percent of the asset value each year, or a cumulative total of 80 percent of the asset value. That is not a cost-effective solution.) This suggests that the optimal strategy for a student who is already a high school senior is to liquidate the brokerage account immediately, spend as much as possible of the student's money on the student's education this year, and put the rest of the money in a custodial 529 plan account for subsequent years. The parent should not tap into any of the parent's money until the student's assets are spent down to zero.