Protecting College Savings from Creditors – Unlike Federal Bankruptcy Law, California’s Enforcement of Judgment Law does not protect the various types of Qualified Higher Education Savings Accounts, including so-called “529 College Savings Plans”. Thus, for example, if a California resident owns a 529 College Savings Plan and owes money to a judgment creditor then the judgment creditor can proceed against the 529 College Savings Plan just like any other asset not exempt from judgment collections.
Unless a debtor files for and obtains relief through a Federal Bankruptcy petition before the creditor levies on the account, or else lives in one of 27 or more other states that do protect college savings accounts, the college savings account owned by the debtor may be lost to their judgment creditors. So how can a California resident protect the money he or she has set aside to pay the future college tuition costs, etc., of his or her children, grandchildren, or other relatives, from levies by his or her own creditors?
One possibility is to gift the money, sooner than later, so that the account is no longer available to that person’s subsequent creditors. A simple approach, but not without risk, is to gift the money to a trusted relative who lives in another state where college tuition plans are protected from claims by creditors of the account owner. Have the relative establish the college savings plan.
For example, a parent gifts money to an aunt or uncle of one of his or her children. The aunt or uncle then establishes a section 529 college savings plan for the parent’s children. Naturally, as the account owner, the aunt or uncle has important powers over who benefits from the plan including controlling who benefits. So the parent, in this scenario, would only use this approach if he full confidence in the aunt or uncle.
Alternatively, the parent might establish an irrevocable trust for the education of the parent’s children and/or grandchildren, and then gift the money to the trustee, who would establish college savings plans owned by the trustee. The irrevocable trust approach is a completed gift of the money because unlike the revocable living trust the irrevocable trust is not available to pay the settlor’s needs and debts.
An irrevocable trust also offers much more assurance and estate planning flexibility for the parent’s intended beneficiaries than gifting to a trusted relative. The trust can also serve other purposes than paying for education. A trust, however, entails attorney fees to establish the trust and may entail trust tax return preparation fees.
Timing is everything. Whenever a person makes a gift there is always a chance that the person’s creditors may later seek to reverse the gift claiming that it was a so-called “Fraudulent Conveyance”. To avoid this, the parent, in our scenario, would be making periodic gifts either to the trusted relative or else to the Trustee of the Irrevocable Trust before anything bad happens that subsequently results in a lawsuit. What if the parent were to make a large gift either soon after an event occurs that results in a lawsuit (such as an accident) or worse yet soon after an adverse court judgment is entered against that person? Those gifts might arguably be reversed as “Fraudulent Conveyances”.
Saving for higher education costs involve balancing many unforeseen risks. Unfortunately, living in California means one of these risks is that qualified higher savings accounts are available to one’s creditors, just like any other non exempt asset. Knowing this risk, however, a person may choose to act proactively and to legitimately put the money beyond the reach of one’s creditors. Doing so, however, all depends on acting timely.
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