Protecting College Savings in Bankruptcy

Tax-advantaged college savings plans are a relatively new financial tool, but are used by many families across North Carolina to save for the expense of a college education. If contributions have been made consistently, a 529 plan may have grown to be a substantial asset. For individuals who have come into troubled financial times, the effect bankruptcy may have on these savings can be concerning. Outside of bankruptcy, a desirable feature of a 529 plan is that the contributing parent remains in control of the deposited funds. However, this means the savings--even if saved for a particular child--are still the parent's asset and potentially available to pay other debts.

North Carolina provides a statutory exemption to protect 529-qualfied plans from collection efforts, as well as in bankruptcy. This exemption, provided by NCGS 1C-1601(a)(10), is subject to several important limits. First, there is a maximum of $25,000 that can be protected by means of the exemption. Second, contributions made within 1 year of filing bankruptcy cannot be protected, unless they represent ordinary contributions consistent with prior contributions. Third, the account must be for a child and actually used for the child's education. Ultimately, many debtors will find that these limitations do not impact their account(s), and they are able to claim them as exempt and retain them through bankruptcy.

A few general observations can be made. As with retirement accounts, it is generally a bad idea to deplete 529 college savings accounts to pay debts prior to bankruptcy, as the funds in the account can be protected and are likely difficult for a debtor to replace. Furthermore, if you have college savings, they should be placed in a 529 qualified plan. To do otherwise may deprive them of protection if you have a temporary financial hardship, and the 1 year restriction rewards advance planning. Lastly, due to the 1 year restriction, opening 529 accounts shortly before bankruptcy is unlikely to provide the debtor with any additional protections.

Claims of exemption for college savings plans under 1C-1601(a)(10) are relatively uncommon. As such, the exact application of the $25,000 limitation may be open to some further judicial interpretation. However, straightforward application of the statute would require summing the debtor's interest in all 529 accounts and comparing against the $25,000 cap. The cap is somewhat confusing, as parents often view 529 accounts as for particular children. As an illustrative hypothetical example, assume a husband and wife jointly own three $10,000 accounts, one for each of their children. If they successfully protect all $30,000, it is not because of each child's $10,000 account is less than $25,000, but rather because each parent's total interest of $15,000 is less than $25,000.