Trust Owned 529 Accounts

Take-Away: A trustee can own and control an IRC 529 account. However, it is possible that the terms of the trust instrument might impose limits on the amount of control that the trustee can exercise over the IRC 529 account.

Case: Alberhasky v. Alberhasky, Iowa Court of Appeals, No. 18-0927 (May 15, 2019)

Facts:  Hard feelings generated by a divorce seem to best explain what happened.

Max sued his father, Rod, for breach of his fiduciary duties as trustee of the Allie Alberhasky Trust, a trust established by Max’s grandmother (for ease of reference simply called ‘Allie’s trust.’)

The dispute between father and son goes back to the time that Rod obtained a divorce from Max’s mother in 1999. As is often the case in divorces, Max and his brother, Grayson, ‘chose sides’ in the divorce. Max opted to live with his mother after the divorce. Grayson opted to live with Rod.

Rod’s mother, Allie, established a revocable trust in 2000. About 9 years later Rod became co-trustees of Allie’s trust along with Allie. In 2010 Allie’s trust enrolled in the Iowa Advisor 529 Plan with Max named as beneficiary of the 529 Account; Allie deposited $65,000 into the 529 Account denoted “FBO Max Alberhasky.”  A similar 529 account with an identical amount was established by Allie’s trust for Max’s brother, Grayson. Allie died in 2011.

In 2012 Rod, acting as trustee of the Allie trust, modified the 529 Account established for Max. Rod changed that 529 Account beneficiary from Max to Grayson (the son who opted to live with Rod after the divorce.) Max sued Rod, his father. Welcome to the world of probate litigation.

Contested Issue: Max claimed that Rod owed to him fiduciary duties with the handling the 529 Account that the Allie Trust had established for Max. Max asked the court to void the change in beneficiary designation of the 529 Account- changed by Rod naming Grayson as its beneficiary. Max also sought an award of damages that resulted from Rod’s breach of fiduciary duties. Rod responded that the 529 Account owned by the Allie trust was not subject to the Iowa Trust Code and that Max lacked legal standing to challenge the change in 529 Account beneficiary designation because only 529 Account owners are authorized to change the beneficiary, as the owner deems appropriate. Further adding to the family dysfunction, Grayson was permitted by the trial court to intervene in the Max-Rod litigation because Grayson had a direct financial interest in the outcome of the pending legal proceedings.

District (Probate) Court: The trial court dismissed Max’s lawsuit against his father. The trial judge found that Max lacked legal standing to challenge how the 529 Account was controlled by its owner, Rod the trustee. The judge also noted that there was no authority to support Max’s claim that a 529 Account is subject to the Iowa Trust Code. No surprise, Max appealed.

Court of Appeals: The Iowa Court of Appeals reversed the trial court’s dismissal of Max’s petition and sent the dispute back to the lower court. As part of its decision, the Court of Appeals noted that it is possible that a 529 Account could be a permissible investment under the terms of the trust. In the process of reaching this interpretation of the Iowa Trust Code (thereby sending the case back to the trial court) the Court cited extensively from an article written by the prominent estate planning attorney, Susan T. Bart:

To bolster the district court’s conclusion, Rod quotes secondary sources explaining the lack of fiduciary duties connected with ownership of 529 plans. For example: 

“The account owner of a section 529 savings account has no fiduciary duties to the beneficiary of the account. Thus, the account owner could change the beneficiary or withdraw the funds himself or herself and the beneficiary would have no grounds for complaint even if the account owner’s actions clearly violated the donor’s intent.”

Susan T. Bart. The Best of Both Worlds: Using a Trust to Make your 529 Savings Accounts Rock, 24 ACTEC J. 106 (2008)

However, Rod overlooks passages in those same articles discussing the effects of enveloping a 529 plan within a trust. Such as:

“A trust-owned 529 account may be the only mechanism to ensure that the donor’s wishes are carried out. If a trust is the account owner, the trustee is bound by the terms of the trust and has a fiduciary duty to the trust beneficiaries. When the primary objective is to fund a section 529 saving account, placing a trust wrapper around the section 529 savings account can restrain within fiduciary confines some of the tremendous flexibility permitted under Code section 529.” Id. At 107.

The Court concluded that while an individual 529 account owner is able to change the beneficiary designation, such freedom does not automatically supplant fiduciary duties imposed on a trustee in the management of the trust-owned 529 plan. Stated differently, the trial court was directed to determine whether Allie created a trust (within a trust) for Max by expressly investing in the 529 Account as Max alleged in his petition. Consequently, the property held in the Allie trust at the time of her death was to be considered by the trial court in the determination of Allie’s purpose in creating the trust. The Court concluded:

Assuming-as we must- the trust of Max’s factual allegations, the funds in the 529 plan were held in trust for Max. In addition, if Rod, acting as trustee, depleted those funds out of animus towards Max, that action could constitute a breach of fiduciary duty entitling Max to relief.

Conclusion: Many individuals are unaware of a trust’s ability to own 529 accounts that are established for trust beneficiaries. A 529 account is a permissible investment that can be held by a trustee. A 529 account can even be exploited, comparable to a trustee investing a cash-value life insurance policy, as a deferred income investment if the trust is already at the highest marginal federal income tax bracket. While investing in a 529 account brings its own ‘baggage’, e.g. the 10% penalty if the 529 Account funds are not used for authorized educational expenses, it still can be an effective investment, especially if one of the material purposes of the trust is to pay for a beneficiary’s education.