529 Education Accounts For Asset Protection

Last edited 206 days ago by Ted Broomfield

Summary

This blog, aimed at the self-directed investor, explains how a tax-advantaged 529 Education Savings Account can be the best first step to asset protection, because this type of investment accounts is relatively immune from creditors, even if the account owners does not declare bankruptcy. A 529 Account is relatively simple and cost-effective when compared to more complex and costly asset protection strategies. An individual can contribute $90,000 in the first year per beneficiary and a couple can contribute $180,000, per beneficiary, though this as an accelerated five-year gift, and full asset protection does not start until two years after such a contribution. Clever planning can create even more asset protection through the use of gifts to relatives who then gift to beneficiaries.

Details

Many investors seek to protect their assets from creditors. Bankruptcy is the Federal Law standard for a person or entity to obtain relief from creditors. However, bankruptcy is time-consuming, costly, complex, and the person declaring bankruptcy loses a good deal of control over his or her assets.

So even better form of asset protection is to hold assets that are exempt from creditors, excluding bankruptcy.

The common types of investment accounts that offer the greatest degree of creditor protection under California law, in order or greater protection to lesser protection are 529 Education Accounts, ERISA employer sponsored accounts.

529 Education Accounts

529 Education Accounts are tax advantaged investment accounts that are intended to be used for the qualified education expenses of the investor or a family member of the investor. There are no income restrictions to investing in a 529 plan.

Tax Characteristics of 529 Plans

The primary tax advantage to a 529 account is that the earnings accrue free of current income tax. If the earnings are used for qualified education expenses, then, the earnings are not taxed. Additionally, if the donor is not the beneficiary of the 529 plan, amounts in the 529 plan are excluded from the estate of the donor. Up to $35,000 of unused 529 plan assets may be rolled over to a Roth IRA, if the assets have been in the plan for more than fifteen (15) years

However, the contributions to a 529 plan are not tax deductible. Also, if the donor withdraws the assets for use other than qualified education expenses, there is a 10% penalty.

Protection of 529 Assets in Bankruptcy

529 assets are generally exempt from creditors in bankruptcy, and in California even excluding bankruptcy, subject to some limitations.

In bankruptcy, the exemption from bankruptcy assets for contributions made in the one year prior to filing bankruptcy is limited to a total of $5,825, whereas amounts and earnings contributed prior to two years are

Protection of 529 Assets, Excluding any Bankruptcy, in California

Obviously, it is better to protect assets without declaring bankruptcy. In California, 529 plans offer excellent asset protection characteristics, because, the majority of 529 assets are exempt from creditors.

In California, under Civil Code section 704.115, the entire 529 account is exempt from creditors, except for contributions made within two years prior to the claim,. The protection from creditors for funds contributed to a 529 plan made within two years of the claim are limited to the IRS annual gift tax exclusion.

Generally, the donor can contribute $18,000 per year to each beneficiary. For a couple, that’s $36,000 a year.

If the beneficiary is a person other than the donor, then, the donor can contribute up to $90,000 in the first year, as an accelerated gift for the following five years, provided no more contributions are made, and the donor reports the gift for the following five years files an IRS Form 709 Generation Skipping Tax. For a couple, that’s $180,000.

Note, in this scenario, for a period of one year after the gift, only $18,000 is protected from creditors, and for a period of two years after the gift, only $36,000 is protected (double for gifts from two parents).

Furthermore, no further 529 or other gifts may be made to the beneficiary during the next five years. This means that some amounts may be “left on the table,” meaning if the annual gift tax exclusion increases after the gift is made, the donor cannot give that additional amount.

Increasing the Protection of 529 Assets, Excluding any Bankruptcy, through gifting

Clever asset protection strategy could result in additional asset protection through gifting.

Under IRS rules any person may make a gift of up to $18,000 to any other person.

So, imagine a couple with two children, where all four grandparents are alive. The couple can donate $180,000 to each child’s 529 fund, totaling $360,000 immediately. Moreover, each parent can gift $18,000 to each of the four grandparents, summing to $144,000. Then, each grandparent can contribute $36,000 to each child’s 529 education account.

In short, for a family of two parents, where four grandparents are alive, a total of $504,000 can be contributed to a 529 plan in one year and within two years that entire amount will likely be free from creditors in California.

Caution, unused 529 funds that are withdrawn for non-qualified expenses may be penalized

It is worth noting that unused 529 funds may create a tax liability.

If the donor withdraws unused 529 funds for other than qualified education expense, the donor will pay a 10% penalty and income tax on the earnings portion of the withdrawal, subject to limited exceptions.

Those limited exceptions include naming a new beneficiary, although caution should be used for naming grandchildren as a new beneficiary, due to the prohibitive generation skipping tax.

As stated above, for assets in a 529 plan at least 15 years, up to $35,000 may be rolled over to a Roth IRA.

Other options include withdrawal tax free if the beneficiary receives a scholarship, or naming yourself as a new beneficiary and taking continuing education.

Conclusion

Although limited, the 529 plan offers an easy, cost effective and powerful tool to get amounts of $90,000 per beneficiary for a single person and up to $180,000 per beneficiary for a couple, with more for larger families protected from creditors within a relatively short period of time of two years.

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