How to Use a 529 Plan to Pay Back Student Loans?

Families can now use 529 college savings plans to pay off all or part of their student loans — for the most part.

Every Community’s Institution for Pension Improvement Act of 2019 [P.L. 116-94]also known as the SECURE Act, changed the definition of qualifying benefits of a 529 plan so that 529 plans can be used to repay principal and/or interest on qualifying education loans of the beneficiary and the beneficiary’s siblings .

However, there are some rules and warnings you should know before withdrawing from your 529 plan to repay your student loans. Let’s dive in.

Restrictions on Using 529 Plans to Repay Student Loans

Qualifying benefits are limited to $10,000 per borrower. This is a lifetime limit that applies to benefits from all 529 plans. So you can’t get around the limit by distributing multiple 529 subscriptions.

For example, if you have a parent’s 529 plan and a grandparent’s 529 plan for the same beneficiary, and take out $10,000 from each to pay back the beneficiary’s student loans, $10,000 of the $20,000 benefits not qualified. The beneficiary is limited to a maximum of $10,000 in student loan repayments from both 529 plans combined. The borrower cannot get around the $10,000 limit by having two or more 529 plans.

Likewise, if you have two parental 529 plans, one for the beneficiary and one for the beneficiary’s sibling, up to $10,000 combined from the two 529 plans can be used to repay the beneficiary’s student loans. .

Likewise, once a borrower receives $10,000 in total qualifying benefits to repay the borrower’s student loans, no further benefits will be qualified to repay the borrower’s student loans. It’s a lifetime limit, not an annual limit.

The $10,000 limit is per borrower, not per 529 subscription. If a borrower receives $10,000 in 529 plan payments to repay their student loans and then refinances the remaining debt in someone else’s name (e.g., their spouse’s name), the new loan may be eligible for an additional $10,000 in qualifying benefits, provided the new borrower has not yet reached the $10,000 limit for their own student loans.

The definition of sibling includes siblings, stepsisters and stepsisters.

529 plans can also repay parent loans

The account owner can turn the beneficiary into a parent and use it to pay off up to $10,000 in parent education loans as well. If each parent has borrowed parental loans, the account owner can change the beneficiary from one parent to another to pay off that parent’s student loans.

Since the limit is $10,000 per borrower, it doesn’t matter if the parent has parent loans for their children and student loans for their own education. The total of qualifying benefits is limited to $10,000 for all education loans.

Not all student loans are eligible

The definition of a qualified education loan includes all federal loans and most private student loans. But some private loans are not eligible.

To be considered a qualified education loan, the loan must meet these requirements:

The loan must have been borrowed solely to pay for higher education expenses. Mixed-use loans, such as credit cards and equity loans, are not eligible. Loans that, when combined with financial aid and other student loans, exceed the cost of attendance are not eligible. to the borrower (defined as siblings, spouses, ancestors, and direct descendants) are not eligible. The loan must be borrowed within 90 days of the date the tuition fees are paid. Loans for expenses from previous years are not eligible. The student must be enrolled at least half-time during the study period for which the loan was borrowed. This means that loans taken out after the student graduates, such as bar student loans and lodging and relocation loans, are not eligible. The student must be enrolled in a diploma or certificate program. Continuing education loans are not eligible. Loans to pay for dual enrollment programs are not eligible. The student must be enrolled in a college or university that is eligible for Title IV federal student grants. Qualified higher education expenses are based on the definition of participation costs in the Higher Education Act of 1965, which was enacted on August 4, 1997. Subsequent changes to the definition of attendance costs, such as the addition of fees for the purchase of a personal computer and for the cost of obtaining initial professional credentials and licenses does not apply. Any loans that paid for these additional costs are not eligible.

Some states DO NOT follow federal rules

Some states have not adopted the federal definition of qualified spending. Accordingly, using a 529 plan distribution to repay student loans may be considered unqualified by the state, even if it is considered qualified by the IRS. The profit portion of such distribution may be subject to state income tax. There may also be a recapture of any tax benefits from the state attributable to the unqualified distribution.

Impact on the interest deduction for student loans

The IRS does not allow you to double dip. A coordination restriction reduces eligibility for the student loan interest deduction when a borrower’s student loans are repaid using a qualifying benefit from a 529 college savings plan.

The student loan interest deduction provides taxpayers with an above-average income exclusion for up to $2,500 in interest paid on qualified education loans.

The amount of interest that qualifies for the student loan interest deduction is reduced by the income portion of the 529 plan distribution used to repay the borrower’s qualifying student loans.

For example, suppose one-third of the 529 plan distribution comes from revenue. If the beneficiary receives a $10,000 benefit to repay student loans, $3,333 of the benefit will come from income. Since $3,333 exceeds $2,500, the borrower is not eligible for the student loan deduction that year.

On the other hand, if only 10% of the benefit was income or the benefit amount was only $3,000, the eligibility for student loan interest deductions would be reduced by $1,000, making the borrower eligible to take up to $1,500 in interest deductions. for student loans on their federal income tax return.

The profit portion of a 529 plan distribution is proportional. Unlike a Roth IRA, the account owner cannot take a contribution-only distribution.

However, if there are multiple 529 plans, the account owner can choose to take a distribution to repay the 529 plan student loans with the lowest percentage of income to qualify for the student loan interest deduction.

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