Can I use a 529 to pay off student loans? Yes!
A 529 plan could be a great vehicle for financing education and can now be used strategically to pay off student loan debt, thanks to the SECURE (Setting Every Community Up for Retirement Enhancement) Act.
How does a 529 plan work?
This payment option is made possible by extending the Federal Tax Code to the term "qualified higher education expense." In addition, it now includes a reference to amounts paid in principal or interest on any eligible loan from the named beneficiary or a sibling of the named beneficiary.
However, ineligible tuition fees paid with funds from a 529 account would result in a 10% penalty, in addition to federal (and possibly state) income taxes on the withdrawal earning portion. So this change in the law is a win for people who want to use 529 money to pay off student loan balances without penalties.
Keep in mind that there is a lifetime limit of $10,000 that can be used in a 529 plan to pay off student loans tax-free in most states. But the limit of $10,000 applies to each beneficiary.
Using 529 money to pay off student loans?
Step 1: Check the definition of qualified education expenses in your state
Before you make a distribution from your 529 accounts, make sure your state has accepted the extended federal definition of "qualifying higher education expenses," which includes student loans as qualifying expenses. Call the customer support center for your plan to ask.
If your state includes student loan payments as qualifying expenses, you or your account holder will avoid paying a 10% fine and federal (and state, if applicable) income on retirement income.
Check state laws for their possible tax consequences for withdrawals and contributions. For example, if you move or are managing a 529 account to another state, check the laws of the state where the account is held and where you live and file taxes.
Many states provide tax benefits for contributions to a 529 plan. These benefits may include the deduction of state contributions to income tax or appropriate grants but may have different restrictions or requirements. Additionally, savers can only qualify for these benefits if they invest in a state-sponsored 529 plan.
Some states also offer multiple types of 529 plans and allow you to have multiple plans. Always consider your state plan because it may provide residents with state taxes or other benefits.
Step 2: Withdraw the amount you want to apply to your student loans
Withdrawals can be made in fixed amounts or periodically over time. You can request a cancellation by mail, phone, or on the plan's website.
You can pay the institution, send it directly to the beneficiary, or reimburse yourself. But no matter which payment method you choose, be sure to keep all sorting receipts.
And remember, the SECURE Act sets a lifetime limit of $10,000 per beneficiary on account funds used to pay off student loans.
Step 3: Apply the distribution to your student loans
It is important to consider the tax implications of the 529 withdrawal. Withdrawals from your 529 account must coincide with the payment of your student loans in the same fiscal year.
Suppose you withdraw 529 money in December but don't pay off your student loan in January. In that case, you run the risk of not having enough qualifying expenses during the year of the 529 withdrawal (for example, if you paid back the student loan balance with the 529 disbursements).
In addition, if you make a distribution in January to pay for the expenses from the previous December, that distribution will not be eligible.
529 plans and taxes
There's no double-dip, so to speak, with the deduction of interest on student loans. No deduction will be permitted for any amount for which a deduction is permitted under any other provision.
Therefore, with the deduction of interest on student loans, it is not possible to deduct interest on a paid student loan using an earning distribution from a 529 to the extent the income is treated as non-taxable. After all, it was used to pay the interest on the student loan.
Some states have not automatically conformed to the federal definition of "qualified higher education expenses that came into effect under the TCJA. Therefore, the extension of the SECURE Act to include student loans may not apply to the state tax deduction.
If the state does not comply with new federal tax laws, the portion of a 529 plan distribution that is used to repay student loans is subject to state income tax.
It is recommended that you check your state's specific laws regarding 529 before using these funds.
How do I take advantage of tax credits and deductions when contributing to a 529 plan?
Follow these steps to get all the benefits of contributing to a 529 plan:
First, make sure that your 529 account offers tax deductions or credits.
Find out if your state offers tax relief to the taxpayer or the account holder.
When the time comes, make contributions and record those contributions on your state income tax return to claim any available tax credits or deductions. You will receive Form 1099-Q from the IRS to help you report these contributions.
While the use of 529 money may only take place or be necessary for limited circumstances, it is good to know that things continue to be more favorable for student loan borrowers.
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