Creditor Protection for Education Plans

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Over the past two weeks, I have reviewed key elements of the new bankruptcy law signed by President Bush last month.  In the first article, I discussed how the new law will make it very difficult to qualify for Chapter 7 bankruptcy and thereby wipe out your debts and give you a fresh start.  Instead, you will be forced to file under Chapter 13 bankruptcy, which requires you to get on a court supervised repayment plan.  The purpose of this part of the law was to end the cycle of abuse where people would borrow money to support a lifestyle they couldn’t afford and then file Chapter 7 bankruptcy to wipe out all their debts. Once they were debt free, they would begin the cycle all over again.

My second article offered good news for IRA owners.  The new law provides federal creditor protection for IRA accounts up to $1 million.  It also provides unlimited creditor protection for monies rolled over to an IRA account from qualified plans such as a 401k plan or profit sharing plan.  This is great news since in the past, creditor protection for IRA accounts was left up to each individual state to decide.  For creditor protection, retirement accounts should now be your number one choice of investment.

In this final installment regarding the new law, I want to discuss another area where you can invest without fear of creditors.  Prepaid tuition plans such as the 529 plan and the Coverdell Education Savings Accounts (ESAs) now receive federal protection in bankruptcy.  Again this is great news because if you were to end up in a bad financial situation, two things you would really want to protect are your retirement savings and education savings for your children.  One protects your retirement years while the other protects your children’s future.

Let’s take a closer look at how these plans work:

529 plans.  If you are concerned about funding your child’s college expenses and are concerned about asset protection, the 529 plan is an excellent tool.  First, you can put a lot of money in these plans.  For example you can invest up to $11,000 per child, $22,000 if you are married.  This annual gift limit is associated with any gifts.  If you want to put more money in than this, the law allows you to contribute up to 5 years worth of annual gifts at one time.  This means that you could contribute up to $55,000 per child now ($110,000 per child if you are married).  These funds will grow tax deferred and when withdrawals are made to pay for qualified college education expenses, they are tax-free.  And there’s more.  You control the money, not your child.  If, after paying your child’s college expenses, you have money left over, you can use it for another child, a grandchild or niece or nephew.  You can even write a check back to yourself although you would owe taxes on your gains plus a 10% federal penalty.  There are no restrictions on who can contribute to a 529 plan.  Alabama’s 529 plan was recently rated one of the worst in the country, so you may want to consider the 529 plan offered by another state such as Utah.

Coverdell Education Savings Accounts (ESAs).  For a given beneficiary, a total of $2,000 may be contributed each year on a non-deductible basis to an ESA.  The funds grow tax deferred and when used to pay for qualified education expenses, are tax-free.  What is particularly attractive about ESAs is that the funds can be used for either private or public schools and you can use the funds for elementary education expenses as well as secondary education expenses and higher education expenses.   There are a number of restrictions:
• To be eligible to contribute the full $2,000, your Modified Adjusted Gross Income (MAGI) must be less than $95,000 ($190,000 for joint filers).   There is a contribution ‘phase-out’ for MAGI between $95,000-$110,000 ($190,000-$220,000 for joint filers).
• Contributions to an ESA cannot exceed $2,000 per beneficiary no matter who contributes.  This requires that family members communicate since excess contributions are subject to penalties.
• Unlike the 529 plan, ESAs are not transferable from one beneficiary to another.
• At age 30, any remaining balances in an ESA must be paid out to the beneficiary with gains subject to income taxes plus a 10% federal penalty.

For either 529 plans or ESAs to qualify for creditor exemption, several tests must be passed:

1. The beneficiary must have been a child, stepchild, grandchild or step grandchild in the year the deposits were made.
2. The funds must have been deposited more than 365 days in advance of filing for bankruptcy.
3. During the 720 days before filing for bankruptcy, only the first $5,000 per beneficiary is protected.

Obviously these restrictions require that you do some preplanning.  However, creditor concerns aside, these are excellent tools for funding a child or grandchild’s education.  If you are worried about creditors, you now have 2 reasons to consider the 529 plan and ESA.  For more information and comparisons of various education plans, go to the Research Center at and click on ‘Internet Guide to 529 Plans’.