Section 529 Plans for Education Expenses Not Exempt from Execution under California Law

By Reno Fernandez of Macdonald Fernandez LLP on Friday, July 8, 2016.

On April 21, 2016, the Second Appellate District for the Court of Appeal of the State of California ruled that savings plans for qualified education expenses created under 26 U.S.C. § 529 are not exempt from execution of a judgment under California law. The court also overturned the trial court's determination that the debtor's retirement plans are fully exempt for further consideration of his means of support.

In O'Brien v. AMBS Diagnostics, LLC (2 Dist. Apr. 21, 2016) No. B263364, 2016 WL 1612875, ___ Cal.Rptr.3d ___, AMBS Diagnostics, LLC sought to enforce a judgment in the amount of $622,957.21 against Timothy O'Brien, who filed a claim of exemption contending that his three section 529 savings plans totaling $54,765.39 and his four individual retirement accounts (IRA's) totaling $465,350.04 were all fully exempt as retirement accounts under California Code of Civil Procedure Section 704.115.

A savings plan created under Internal Revenue Code Section 529 allows an individual to contribute money after paying taxes and later withdraw from it without paying income taxes or capital gains taxes if the withdrawals are used to pay the qualified higher education expenses of the beneficiary. If not, the holder must pay income taxes plus a 10% penalty. O'Brien set up three such accounts for his three children.

The trial court ruled in O'Brien's favor and exempted all seven accounts. In the course of doing so, the court noted that there is no statutory or case authority to exempt section 529 plans but reasoned that the same public policy applies to protecting both retirement plans and section 529 plans, with the protection of money held in trust for a child's education possibly being an even greater reason for protection.

AMBS Diagnostics appealed. On appeal, O'Brien argued that courts should look to Bankruptcy Code Section 541(b)(6), which excludes section 529 plans from a debtor's estate such that they cannot be used to satisfy creditors' claims, with certain exceptions. However, the court noted that a bankruptcy case was never filed, and federal preemption does not apply prior to bankruptcy.

Second, O'Brien argued that section 529 plans fall within the statute protecting retirement plans. However, the court held, section 529 plans are not themselves retirement plans, and the analogy fails as the funds must be used for education purposes, not retirement.

Third, O'Brien argued that the trial court was correct in holding that there are good policy reasons to exempt section 529 plans. Noting that 27 other states have exempted section 529 plans by statute - but California had not - the court held commented that only the legislature can expand exemptions or create new exemptions.

Accordingly, the court reversed the trial court's ruling. Moreover, because the trial court did not sufficiently consider O'Brien's means of supporting himself in retirement outside of his retirement plans, the court remanded for consideration of how much of his retirement plans are necessary for his support and the support of his spouse and dependents.

This case highlights the importance of comparing the exemptions provided in state law with the exemptions and exclusions available in bankruptcy, which in some cases are stronger. For amounts contributed more than two years prior to bankruptcy, Section 541(b)(6) provides an unlimited exclusion for section 529 plans. This can make a significant difference in the lives and educations of a debtor and his or her family.