In my last post, I wrote about the estate planning benefits of grandparent gifts to 529s for grandchildren. The benefits are significant – estate and gift tax savings, minimal risk of beneficiary misuse, continued control, simplicity – and for those reasons gifts to 529s are a great estate planning technique. My post generated some interesting follow up questions that I address here.
Will a 529 plan funded by a grandparent affect college financial aid?
Yes – a 529 plan funded by a grandparent will affect the grandchild’s college financial aid. How exactly is a bit complicated, and depends upon how the 529 account is owned.
Grandparent Owned Accounts: 529s of which the grandparent is the owner (or “participant”) need not be reported as an asset on the grandchild’s FAFSA (Federal Application for Student Aid). Nevertheless, the 529 will affect the grandchild’s financial aid. This is because withdrawals from a grandparent owned 529 to pay for college must be reported as the grandchild’s income on the next year’s FAFSA. These withdrawals will therefore significantly reduce the next year’s financial aid.
Parent or Grandchild Owned Accounts: 529s owned by the parent or the grandchild must be reported as an asset on the FAFSA, and will reduce the grandchild’s financial aid by 5.64% of the account’s value. Withdrawals from a parent or grandchild owned 529, however, need not be reported as the parent or grandchild’s income on the FAFSA.
Based upon these facts, in terms of the impact on financial aid, it is typically better for the account to be owned by the parent or grandchild, rather than the grandparent.
The website www.savingforcollege.com offers some creative ways to avoid the potential negative impact of grandparent owned 529s on financial aid. These strategies are worth considering, but some may not work and may have negative tax consequences. I do not endorse them. To see for yourself, visit http://www.savingforcollege.com/articles/avoiding-the-financial-aid-trap-with-grandparent-529s?page=1.
Are assets in a 529 plan protected from creditors?
Federal bankruptcy law exempts 529s from bankruptcy estates in most circumstances. Section 541(b)(6) of the Bankruptcy Code exempts 529s established for the benefit of the debtor’s child or grandchild, provided the funds were contributed at least two years prior to the bankruptcy. Funds contributed between one and two years prior are protected up to only $5,000.
Whether 529 plans are protected in a lawsuit or claim outside of a bankruptcy is a different question. The answer depends upon the law of the state in which you live. About half the states have enacted an asset protection statute that protects 529s from creditors of the beneficiary, account owner, donor, or one or more of those persons. For example, Florida law protects the 529 from the creditors of all three. New Jersey law, however, protects the 529 from the creditors of only the beneficiary and the donor, not the account owner.
Not surprisingly, Massachusetts has not enacted an asset protection statute for 529s. Thus, the law in Massachusetts is uncertain. Massachusetts residents who own or fund 529s should not count on those assets being protected from the reach of creditors.
Nonetheless, I have some thoughts for Massachusetts residents concerned about this issue.
(i) A 529 donor who is not also the account owner has given up control of the account and cannot withdraw funds from the account. Creditors generally have more difficulty reaching assets outside the control of the debtor. Thus, it makes sense for a donor concerned about creditor protection to make someone else (e.g., a spouse, an adult child) the owner of the 529.
(ii) Some states permit a Trust to be the account owner of a 529. Even in a state without sufficient protection, making a Trust the account owner may add an additional layer of creditor protection. Of course, the Trust must be established before the 529 can be opened.
(iii) Massachusetts residents may want to consider opening a 529 in a state with a protective statute to obtain protection from the foreign state’s statue. Whether a Massachusetts court would actually apply that statute in a lawsuit against the Massachusetts resident is a complex question, however, and depends upon Full Faith and Credit constitutional principles.
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