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What Happens to College Savings Plans in Bankruptcy?

A commonly discussed topic in the news is the rising costs of higher education in the United States. Congress has tried to help parents (and grandparents) pay for their children’s higher educations in two ways. One is by allowing them to pay into a tax-protected entity frequently referred to as a “section 529 college savings plan,” or, “529 plan,” or the like. Another is a section 530 education individual retirement account (“education IRA” or “section 530 plan,” etc.). Like many funds, their names come from the sections in the tax code that authorizes them. Both entities operate like trust funds. There’s a “settlor” who creates the account or funds it and a beneficiary who is supposed to receive the money.

Some settlors deposit quite a bit of money into these funds, and if they fall on hard times, can the trustee liquidate them?

Short answer: Generally no.

Rather than subjecting such accounts to an exemption, the Bankruptcy Code excludes them from the bankruptcy estate itself, depending on the circumstances. The obvious reason for this is that some states don’t allow their debtors to use the federal exemptions, which would jeopardize these accounts in bankruptcy.

Instead, Section 541(b)(5-6) carves out special exclusions for money deposited into these plans.

  • Anything deposited more than two years before the settlor-debtor filed bankruptcy is exempt.
  • Up to $6,225 deposited between one and two years is excluded.
  • Anything within the previous year can be included in the bankruptcy estate.

Any amount that is not excluded can be placed into an exemption if the debtor has any available.

There are a few other rules that apply for the exclusions to apply. The beneficiary must be a (step)child or (step)grandchild of the settlor. For 530 plans, the deposits can’t be “excess contributions” as defined by the IRS, and for 529 plans, any contributions beyond what the IRS permits are also ineligible for exclusion.

Congress was very careful in giving debtors a mechanism for shielding tax-protected college savings plans from bankruptcy, so you shouldn’t have to worry about what will happen to them. If you do use either of these plans, though, and they’re either over-funded or over-contributed, then you’ll definitely want to discuss the matter with an experienced New York bankruptcy lawyer.

For answers to more questions about bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced bankruptcy trustee actions Bruce Weiner for a free initial consultation.

Rosenberg, Musso & Weiner, L.L.P
26 Court St # 2211
Brooklyn, NY 11242, USA

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