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Saving for your child’s education is smart, but isn’t always easy. What happens if you scrimp and save but then a debt collector threatens to take it all away? Are college savings accounts safe from creditors?

A reader who goes by the name “Wonder,” asks: “If I lose a civil lawsuit, can they collect my daughter’s college fund?”

Another question our reader probably should have asked, but didn’t, is what would happen to that money if she files for bankruptcy, since consumers who are being sued for debts they can’t pay often seek relief in the bankruptcy courts.

As is often the case in these kinds of situations, the answer is “it depends.” It depends on the way the money has been socked away, state laws and even how recently savings were put into the account.

Chances Are, You’re Safe

The most popular type of college savings account is the 529 savings plan. Generally, there are up to three parties involved in one of these accounts: the owner (often the parent), the donor/contributor (which may be the same person, but could be another relative) and the beneficiary (the person who will benefit from the funds).

Under federal bankruptcy law, contributions for a beneficiary child, grandchild, stepchild or step-grandchild are usually safe if the beneficiary or donor files for bankruptcy (with caveats, discussed later). If the owner of the account files for bankruptcy, funds are often protected under federal and state laws, but not always (and again, with caveats).

In addition, “about half the states have general creditor protection for claims outside bankruptcy,” says asset protection attorney Ike Devji. But even in those states where there are laws protecting these funds, the level of protection can vary.

State laws vary with regard to whose interests are protected. In some states, for example, if there were a judgment against the beneficiary, funds would be protected. But if the donor lost a lawsuit, that money might be at risk. (Morningstar publishes a list of state protections for 529 saving plans and the Corporation for Enterprise Development publishes a list as well. However, state laws change so be sure to consult an attorney for specific advice.)

Locking Them Down

Devji says that some of his clients use trusts, which are more flexible because you can put real estate or other valuable property into the trust. “If we have a high net worth person who wants to earmark a certain gift we would create an ICT – an irrevocable children’s trust – which can include a variety of assets without the limitations on the 529 side.” That trust can then be earmarked in whole or in part to cover educational expenses.

But in order to protect the assets of the trust from creditor’s claims, it must be set up properly. It requires a grantor, a beneficiary and a third-party trustee who is neither the grantor nor the beneficiary.

“Neither the person making the gift, nor (the one) receiving the gift have any control over how and where or if the proceeds get used,” Devji says. “If you have discretionary control and you are sued—for example, a malpractice lawsuit—or file bankruptcy, it could be at risk.”

Plan Ahead

One strategy likely to backfire is trying to dump money into these savings vehicles after you’ve already found out you are facing a lawsuit or bankruptcy. It fails for a couple of reasons, says Devji. The first is the limit on how much can be contributed to these plans without running into gift tax problems. (It’s generally $14,000 per individual per year, but there are ways to increase that amount.) The second is that action may be considered “fraudulent conveyance,” which can “take a bad situation and make it worse,” he warns.

In addition, in the case of bankruptcy, Devji warns that there is a “lookback period” during which transfers made too close to the bankruptcy filing can be reversed. “You might lose the last year or two (of savings),” he says. However, an account funded years ago should be safe, again depending on who is filing for bankruptcy and if the funds are considered “exempt” from bankruptcy claims under state law.

No one plans to run into financial problems, or even in most cases, to file for bankruptcy. But despite the best planning, a serious illness, natural disaster, business failure or unemployment can throw even the best-laid plans into a tailspin. And for that reason, if you’re being proactive about saving for your child’s education, it’s also smart to find out if you are doing it the right way—and what might happen if something goes wrong.

And, if a debt collector threatens to take your kid’s college savings, take note. It may be an illegal threat under federal law. “The Fair Debt Collection Practices Act (FDCPA) does not allow collectors to threaten things they cannot do,” says Michael K. Bane, managing attorney, Hyslip & Taylor LLC, LPA. Since these accounts are often off-limits to them, “anyone who has experienced such a threat would be best served speaking with an attorney who specializes in the FDCPA to see if the collector has broken the law,” he says.

Knowing your rights when dealing with debt collectors is crucial. (Here’s a helpful guide for handling collection accounts.) Having these accounts on your credit reports can hurt your credit ratings for years to come. You can get your free annual credit reports from AnnualCreditReport.com to see if you have any accounts in collection. And you can check your credit scores for free on Credit.com to see how those collections are impacting your scores. But more importantly, if you don’t know your rights you may be pressured to pay debts you don’t owe, or with money you need to pay other, more essential bills.

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