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529 E-ditorials

05-2: 529s and the new Bankruptcy Act
Joe Hurley
Thursday, April 28th 2005

Last week, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was signed into law by President Bush. Most provisions will take effect in six months. News stories about the Act have tended to focus on the difficulties credit-card users will face in getting their debts discharged through the bankruptcy court. But scant attention has been paid to the "good news" for college savers: new bankruptcy protections for 529 plan accounts and Coverdell education savings accounts (ESAs).

Fortunately, Congress recognizes that education savings, like retirement accounts, are important enough to deserve special treatment when the owners of those accounts face bankruptcy, particularly in light of questions surrounding creditors' ability to reach such assets under existing federal and state laws. However, the new bankruptcy protection comes with a few strings:

- Full exemption is provided only for funds contributed to 529 plans and ESAs more than two years prior to the bankruptcy filing. The protection is limited to $5,000 for funds held for only one to two years. College savings accounts less than one year old are not shielded at all under the new provisions.

- The account beneficiary must be the debtor's child, stepchild, grandchild, or step-grandchild. You cannot take advantage of the new protection by establishing a 529 account for yourself.

- "Excess contributions" to ESAs and 529 plans do not qualify for exemption. While excess contributions are clearly defined under the law for ESAs, the definition is much less clear for 529 plans.

One might question the value of the bankruptcy protection when 529 accounts appear already well-protected. A large number of states wrap their 529 plans with special asset-protection laws. Further, the majority of 529 plans are constituted as trusts with "spendthrift" provisions. According to a 2001 article by attorney Barbara Van Arsdale(1), a spendthrift trust not only places the funds beyond the reach of creditors seeking to access the beneficiary's interest before it has left the trust, but also exempts the 529 account from the bankruptcy estate under existing bankruptcy law.

Whether a resident of State A can rely on the debtor/creditor laws of State B when establishing an account in State B's 529 plan, however, is an issue that has yet to be tested in the courts (at least according to the attorneys I have spoken with). Even the protection of a spendthrift provision in the 529 trust agreement may be compromised because the account owner has unrestricted access to the 529 funds. And finally, remember that not all 529 plans have been favored with state-provided protections. For these reasons, the new bankruptcy law provides some much-needed clarity.

The biggest problem with the new law is that it may encourage some people to squirrel away more money than they could ever possibly use for college within multiple 529 plans in an attempt to keep their assets beyond the reach of creditors. Congress obviously did not intend to give wealthy individuals that ability. The word "abuse" has already cropped up in the 529 arena with respect to estate taxes, and both Congress and the Treasury Department have developed proposals that would change some of the estate tax rules surrounding 529 plans. Whether or not people actually abuse 529 plans for estate-tax or asset-protection purposes may not be important. The mere potential for such abuse is likely to generate calls for further reform.

This article is published with the understanding that the author and publisher are not engaged in rendering legal advice. If legal advice is needed, the services of a competent attorney should be sought.

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(1)Van Arsdale, Barbara J. Esq., "How protected is a QSTP account from the claims of creditors?" The 529 Plan Report, Vol. 3, Issue 1 (Savingforcollege.com LLC, 2001).

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» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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