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College Planning Q&A: Creditor Protection in New York

Full protection is not certain under oddly worded New York statute. Plus, coverting Coverdells to 529 accounts, prepaid tuitions, and setting up a 529 in a trust.

Susan T. Bart, 05/25/2007

College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to advisorquest@morningstar.com.

Q. Regarding 529 plan protection from creditors, the New York statute 5205.j.2 has been interpreted by some as meaning that the account is protected from creditors of the adult account owner as long as the beneficiary is a minor. However, the statute wording actually only appears to be protecting debt claims against the minor who is the account owner and beneficiary. If the account owner is the minor who is also the beneficiary, which the New York plan(s) allows, would the assets be fully protected for claims against the adult who funds the account?

Susan: New York has an oddly worded statutory exemption. New York Civil Practice Law & Rules section 5205(j)(3) exempts only $10,000 per account owner from the account owner's creditors. CPLR ยง5205(j)(2) provides a complete exemption where "the judgment debtor is the account owner and designated beneficiary of such account and is a minor." Literally construed, to gain full protection from the designated beneficiary's creditors one would have to make the minor child the account owner.

New York's 529 College Savings Program does permit a minor to be the account owner if a parent or guardian executes the account application, but how does the account management work with a minor account owner? Only an account owner can contribute to the New York program and the program will only accept a check from someone other than the account owner if the check was originally made out to the account owner and has been endorsed by the account owner to the program. Can a minor legally endorse a check?

Further, can the minor change investment options, change the beneficiary, roll over the account, or take a nonqualified distribution? Can the parent or guardian take such actions on behalf of the minor, or can no one take such actions while the account owner is a minor?

In addition, are we really worried about the minor's creditors? In any event, the creditor protection would end when the account owner attains majority, which is the time at which one might become more worried about the potential debts of the account owner beneficiary (i.e., the young adult's credit card and car purchase debts).

If a parent or grandparent is funding a 529 account for a minor, the disadvantages of naming the minor as the account owner easily outweigh the minor advantages of protecting the account from the beneficiary's creditors while the beneficiary is a minor.

You asked whether an account owned by a minor beneficiary would be protected against creditor claims against the adult who funds the account. Full protection is not certain. First, if the parent or guardian funds the account and, acting as parent or guardian, would be permitted to change the beneficiary or refund the funds to themselves, there should be no creditor protection. It is not clear from New York's program description what rights a parent or guardian has over the account. Even if the donor has no rights over the account, the donor's creditors could potentially reach the assets if the transfer was a fraudulent conveyance. As a general matter (without commenting specifically on New York fraudulent conveyance rules) a conveyance is fraudulent if (1) the transfer is made with actual intent to hinder, delay or defraud any pre-existing or subsequent creditor or (2) the debtor received less than reasonably equivalent value in exchange for such transfer or obligation and (a) was insolvent or became insolvent as a result of such transfer or obligation or (b) after the transfer or obligation had unreasonably small capital.

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