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Bankruptcy Protection and 529 Accounts

Protections of 529 assets from creditors in the case of bankruptcy vary by state.

Susan T. Bart, 10/26/2012

Creditor protection for section 529 savings accounts is provided by federal law in the case of bankruptcy (with significant limitations) and in at least 27 states by statute or regulation in the case of creditors' claims generally (which includes creditors' claims brought outside of bankruptcy proceedings).

Federal Bankruptcy Protection
Section 529 accounts generally will not be subject to the claims of creditors in the event of the bankruptcy of the beneficiary if the beneficiary is not the account owner because the beneficiary does not have any legal or equitable interest in the account.

In the event of the bankruptcy of the account owner, the 529 savings account may be subject to creditors' claims because the account owner does have a legal or equitable interest in the account. However, all or part of the account may be excluded from the bankruptcy estate by federal law, or may be exempt by special state bankruptcy exemptions.

In the event of the bankruptcy of the donor to a 529 savings account who is not the account owner of such account, the donor does not have a legal or equitable interest in the account but, depending upon the circumstances, the 529 savings account may be included in the bankruptcy estate under the fraudulent conveyance rules.

Exclusions From Bankruptcy Estate. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "2005 Legislation") provides some significant exclusions from the bankruptcy estate for contributions to 529 savings accounts for certain family members where such contributions were made at least two years prior to bankruptcy, and limited protection for contributions to such accounts made between one and two years prior to bankruptcy.

Bankruptcy Code section 541(b)(6) provides that contributions made to a 529 savings account for a child, grandchild, stepchild, or stepgrandchild more than two years prior to filing the bankruptcy petition are protected to the extent they do not exceed the amounts permitted to be contributed per beneficiary by the program.

Funds contributed to a 529 savings account for a child, grandchild, stepchild, or stepgrandchild more than 365 days but less than 720 days prior to filing bankruptcy are protected only up to $5,850 per beneficiary.

Contributions made to a 529 account within one year prior to a bankruptcy filing, however, are included in the property of the estate.

It is important to note that this is an exclusion from the property of the bankruptcy estate, not an exemption. The rules about what is included and what is excluded from the bankruptcy estate apply to all bankruptcy petitioners, regardless of whether they elect federal or state exemptions.

The Bankruptcy Code section 541(b)(6) exclusion thus applies only to bankruptcy cases filed on or after Oct. 17, 2005 (the effective date of the 2005 Legislation). Several courts have ruled that section 541(b)(6) does not apply retroactively. For bankruptcy cases filed before Oct. 17, 2005, section 529 savings accounts are included in the bankruptcy estate, except as provided under Bankruptcy Code sections 541(c) (exclusion of property subject to a spendthrift provision). The exclusion under section 541(c) generally won't apply to 529 savings accounts because the debtor would have to be the designated beneficiary of the account and the 529 plan would have to contain a spendthrift provision.

Third-Party Contributions. Sometimes persons other than the account owner make contributions to a section 529 savings account. Third-party contributions to a section 529 savings account are also considered property of the bankruptcy estate of the account owner if those contributions are not excluded under Bankruptcy Code sections 541(b) or (c).

State Exemptions. Bankruptcy Code section 522(b) allows debtors to elect to claim either federal or state exemptions from the bankruptcy estate. Most states require debtors to use the state exemption scheme. Thus, even where a section 529 savings account is not excluded from the property of the estate, a debtor may nevertheless protect the account from the claims of creditors if a state exemption applies. See the discussion of State Creditor Protection Statutes below.

Fraudulent Transfers. It is also important to note that, notwithstanding the special protections for section 529 savings accounts in Bankruptcy Code section 541, transfers to section 529 savings accounts could still be disregarded if they are fraudulent transfers under either federal law or applicable state law. Under Bankruptcy Code section 548 prior to the 2005 Legislation, a fraudulent transfer or obligation made or incurred within one year before the petition date could be avoided without resort to state law. The 2005 Legislation extends the reachback period to two years. This provision is effective for bankruptcy petitions filed on or after April 20, 2006.

In addition, Bankruptcy Code section 544(b)(1) provides that a bankruptcy trustee may avoid a fraudulent transfer under applicable state law. See the discussion below of Fraudulent Transfers.

State Creditor Protection Statutes
Click here to download a chart (PDF) of the state statutes I have identified that provide creditor protection to section 529 savings accounts. This chart is a work in progress and may not identify all states that provide creditor protection. Please email me regarding any additional states that should be included in the chart, or of any errors in identifying or describing the relevant statutes (email address is provided in the chart).

Which Programs Are Protected? Most of the states limit the creditor protection to programs established within that state. However, Florida, Tennessee, and Texas appear to provide creditor protection to section 529 savings accounts established under any state's program.

Who Is Protected? A number of state statutes protect section 529 savings accounts from creditors' claims generally, without specifically limiting the protection to the claims of creditors of the beneficiary, the claims of creditors of the account owner, or the claims of creditors of the contributor. Presumably, the statutes of such states would protect the account from the creditors of any of the beneficiary, account owner, or contributor.

Other states specify that the protection is from the creditors of the beneficiary (Wisconsin), from the creditors of the contributor and the beneficiary (New Jersey), from the claims of the creditors of the account owner and the beneficiary (Alaska, Arkansas, Kansas, Kentucky, Maine, Nebraska, North Dakota, Oregon, Pennsylvania, and West Virginia), or from the claims of the creditors of the beneficiary, account owner, and contributor (Colorado, Florida, Illinois, Louisiana, South Dakota, and Virginia).

Where the beneficiary is not the contributor or the account owner, the beneficiary does not generally have any rights over the account (except in the case of a custodianship account, in which case the beneficiary generally has the right to become the account owner upon attaining the statutory age). No specific protection from the creditors of the beneficiary would thus seem to be needed, except in the case of custodial accounts. For custodial accounts held for beneficiaries who are minors under state law, protection would not generally be needed because generally minors cannot incur enforceable debts (with some exceptions). Nonetheless, a statute that expressly protects an account from the creditors of a beneficiary may provide some protection in the event of a custodial account where the beneficiary incurs debts after attaining majority but before attaining the statutory age for distribution of a custodial account.

Protection from the creditors of the account owner is critical, because the account owner generally has the right to withdraw the account. The state statutes specifying who receives creditor protection all include the account owner, except for New Jersey and Wisconsin.

If the contributor or donor is not the account owner, generally the creditors of the contributor would not have rights to reach the account assets because the contributor has no property rights over the account. However, protection from the creditors of the contributor could be important if the creditor could establish that the transfer was made in fraud of creditors. Only a few of the state statutes specifying who receives creditor protection expressly include a donor who is not an account owner. Thus in many states, a debtor may find more protection in depositing money in a section 529 savings account with the debtor as an account owner rather than a section 529 savings account with someone else as an account owner.

Limitations on Protection. Surprisingly, not many of the states limit the creditor protection in ways that would avoid abuse of 529 savings accounts as loopholes from creditor claims. In many of the states with creditor protection, one seemingly could deposit funds in a section 529 savings account, perhaps even after a creditor had begun an action against the debtor, to protect the assets. The debtor could be the account owner, with the ability to withdraw the funds at a later time. With the ability to contribute up to five times the annual exclusion amount per beneficiary in one year without gift tax consequences, section 529 savings accounts conceivably create a very large loophole to avoid creditors' claims. The debtor might even be able to name himself or herself as the beneficiary and still obtain the protection.

A creditor might be able to reach assets in a protected section 529 account by arguing that the transfer was not made with the purpose of funding future higher education expenses of the beneficiary, but rather merely to avoid creditors' claims. The potential success of such an argument has not, to my knowledge, yet been tested by any court. A creditor might also be able to reach such assets by arguing the transfer was a fraudulent transfer. See the discussion below.

A few states impose limitations on the protection from creditors. New York provides protection only in three unusual situations, rendering New York's statute generally ineffective. South Dakota's exemption does not protect contributions to an account within one year of filing a bankruptcy petition. Kansas' statute does not protect contributions made within one year of filing a bankruptcy petition or of a judgment for claims, and protection only up to $5,000 for contributions made between one and two years prior to bankruptcy or judgment. Further, Kansas' protection is limited to lineal descendants of the account owner. Illinois limits the exemption to the amount of the annual gift tax exclusion for contributions during each of the two years prior to filing a bankruptcy petition. North Carolina limits protection to $25,000 and excludes any funds contributed within 12 months of filing for bankruptcy (unless consistent with the debtor's past pattern of contributions), as well as any funds not used for college expenses of the child of the debtor. Finally, Nevada's exemption is inapplicable if the money will not be used to attend college, or if the money was deposited after a judgment was entered against the owner of the account, and is limited to $500,000.

A few states also provide that the exemption is not applicable to avoid child support payments (Alaska, Idaho, and Rhode Island) or divorce claims (Idaho, North Carolina, and Rhode Island).

Fraudulent Transfers
Even transfers to 529 savings accounts that might otherwise be excluded from the bankruptcy estate or subject to a bankruptcy exemption may be included in the bankruptcy if the transfer was fraudulent under state law. Further, in cases other than bankruptcy, assets fraudulently transferred may be subject to the claims of creditors, even if they would otherwise be protected under a state exemption. The applicable law in nearly all states is the state's version of the Uniform Fraudulent Transfer Act (UFTA). The reach-back period under the UFTA is four years, or potentially longer in the case of actual fraud.

Under the UFTA, fraudulent transfers include both "actual fraud" and "constructive fraud." "Actual fraud" includes transfers made with actual intent to hinder, delay, or defraud any creditor. Since direct evidence of actual intent is rarely available, the bankruptcy court may consider "badges of fraud," which are elements that provide circumstantial evidence of the debtor's intent to hinder, delay, or defraud creditors. The badges of fraud include whether the debtor 1) made the transfer to an insider (e.g., a relative), 2) retained possession or control over the transferred property after the transfer, 3) concealed the transfer, 4) had been sued or threatened with suit prior to the transfer, 5) transferred substantially all of his or her assets, 6) absconded, 7) removed or concealed assets, 8) received consideration reasonably equivalent to the value of the transferred asset, 9) was insolvent or became insolvent after the transfer, 10) made the transfer shortly before or after incurring substantial debt, and 11) transferred essential business assets to an insider through a lienor.

With respect to creditors whose claims arise prior to a transfer, the UFTA provides that the transfer is fraudulent if the debtor 1) receives less than reasonably equivalent value in exchange for the transfer and 2) was insolvent at the time of the transfer or became insolvent as a result of it. Proof of the debtor's insolvency is a necessary element of a fraudulent transfer claim under this "constructive fraud" provision.

Even where a debtor transfers nonexempt assets to a section 529 savings account prior to filing for bankruptcy in order to claim the assets as exempt, the court may find that the debtor did not act with actual intent to defraud. For example, the debtor in In re Bronk admitted to transferring proceeds from a mortgage on his home to several 529 accounts established for the benefit of his grandchildren, and that he did so in order to protect nearly $100,000 from creditors. Cirilli v. Bronk (In re Bronk), 444 B.R. 902 (Bankr. W.D. Wis. 2011). Furthermore, he transferred the assets less than three months before filing for bankruptcy and had incurred substantial medical debts prior to the transfers. Despite the presence of these badges of fraud, the court allowed the debtor's discharge and did not disallow his claimed exemptions because he carried out the transfers on the advice of his attorney, and he had not concealed assets, misrepresented his intentions, borrowed money to purchase exempt property, or engaged in "underhanded tactics" against his creditors.

While the court expressed some misgivings about the conversion of nonexempt assets to exempt assets, its sympathy for the debtor in this case clearly outweighed any concerns it had about preventing fraud. The court viewed Bronk not as a dishonest debtor, but rather as an "elderly man" trying to provide for himself in the wake of his wife's death and in the face of "mounting medical bills." Id. at 917. In re Bronk appears to be an extraordinary case that likely demonstrates the outer boundary of what constitutes permissible pre-bankruptcy planning.

To comply with certain Treasury regulations, we state that (i) this article is written to support the promotion and marketing of the transactions or matters addressed herein, (ii) this article is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (iii) each taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

Susan T. Bart is a partner in the Private Clients, Trusts & Estates Group at Sidley Austin LLP in its Chicago office, where her practice includes estate planning, estate and trust administration, and fiduciary counsel. She has written two books, including Education Planning and Gifts to Minors published by Illinois Institute for Continuing Legal Education (iicle.com), which extensively discusses 529 plans.

She is the author of Education Planning and Gifts to Minors 2004 Edition. She is a frequent speaker on trust and estate topics in general and Section 529 college savings plans in particular.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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