Higher Learning: A Potentially Expensive Lesson About 529 Plans

By Karl de Costa

A “529 qualified tuition plan” is an education savings plan designed to encourage and help families set aside funds for future college costs.  It’s named after Section 529 of the Internal Revenue Code, which created this type of plan in 1996.

Americans have an estimated $248 billion currently invested in 529 plans.  And it’s easy to understand why.  Generally speaking, 529 plans offer an impressive array of income tax and estate tax breaks, plus other benefits.

  • Earnings on funds within the plan grow federal and California tax-free as long as the money is taken out to pay for qualified education-related expenses of the designated beneficiary, such as tuition, fees, books, computers, and room and board.
  • Everyone is eligible to take advantage of a 529 plan. And the donor stays in control of the account.  With few exceptions, the named beneficiary has no legal rights to the funds, so donors can be assured that their money will be used for its intended purposes.  (In other words, you, not your sophomore, can decide if that semester in St. Barts is a viable educational opportunity.)
  • They’re fairly flexible, too. Donors can change investment options twice per year, can rollover plan funds into another 529 plan annually, and generally can even change beneficiaries.  (So when your son leaves school to open that surf shop, you may be able to fund your daughter’s eight-year triple-major.)

The primary negatives to 529 plans have generally been thought of as (1) the fact that contributions themselves are not deductible – 529 plans are funded with after-tax dollars; and (2) any earnings withdrawn from a 529 plan that are not spent on eligible college expenses are subject to income tax, and an additional 10% federal tax penalty.  (However, despite the donor’s ability to take back funds they’ve deposited into 529 plans, assets remaining in such plans at a donor’s death are not subject to estate tax in the donor’s estate.)

Well, a recently published California Court of Appeal case, O’Brien v. AMBS Diagnostics, LLC, has added another potential negative to the list:  Assets held in 529 plans can be susceptible to a California donor’s creditors.

In O’Brien, a plaintiff obtained a significant money judgment against the defendant.  The successful plaintiff then tried to collect on that judgment, seeking to levy upon several investment accounts held in the defendant’s name.  The defendant sought an order from the trial court declaring that three of those accounts – 529 plan accounts held in his name as donor, one for each of his children – were exempt from levy.

Based upon a public policy analysis, the trial court agreed with the defendant, granting exemption for all three 529 plan accounts.  Informed by the fact that private retirement accounts are exempt from levy, the trial court reasoned that “protecting monies held in trust for the education of one’s children may even be a greater reason to exempt them” from susceptibility to creditors.

Much like a dorm monitor presented with a colorful curfew excuse, the Court of Appeal was sympathetic, but not convinced.

The Court of Appeal acknowledged that there are good policy reasons to exempt 529 plan accounts from levy:  “The purpose of exempting certain property from levy is to protect enough of the debtors’ property from enforcement to enable them to support themselves and their families…The money a debtor has set aside for his children’s higher education would seem to fall comfortably within this rationale.”

Nevertheless, the trial court’s ruling was reversed.  Noting that California does not have any state statute on the books specifically exempting 529 plan accounts from levy – although at least 27 other states do, as does federal bankruptcy law – the California Court of Appeal took the position that “we certainly cannot go one step further and create a brand new exception from whole cloth, no matter how persuasive the policy reasons that might support it.  We leave that task where our Constitution put it – with our Legislature.”

The O’Brien defendant and his children, have learned an expensive lesson about paying for college.

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