Families can now use 529 college savings plans to pay off all or part of their student loans - for the most part.
The Setting Every Community Up for Retirement Enhancement Act of 2019 [P.L. 116-94], also known as the SECURE Act, changed the definition of qualified distributions from a 529 plan to allow 529 plans to be used to repay the principal and/or interest on qualified education loans of the beneficiary and the beneficiary’s siblings.
However, there are some rules and caveats you need to know before you start withdrawing from your 529 plan to repay your student loans. Let's dive in.
Limits On Using 529 Plans To Repay Student Loans
Qualified distributions are limited to $10,000 per borrower. This is a lifetime limit that applies to distributions from all 529 plans. So, you can’t bypass the limit by taking distributions from multiple 529 plans.
For example, if you have a parent-owned 529 plan and a grandparent-owned 529 plan for the same beneficiary, and take a $10,000 distribution from each to repay the beneficiary’s student loans, $10,000 of the $20,000 in distributions will not be qualified. The beneficiary is limited to a maximum of $10,000 in student loan repayment from both 529 plans combined. The borrower can’t bypass the $10,000 limit by having two or more 529 plans.
Similarly, if you have two parent-owned 529 plans, one for the beneficiary and one for the beneficiary’s sibling, at most $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 qualified distributions to repay the borrower’s student loans, no further distributions to repay the borrower’s student loans will be qualified. It is a lifetime limit, not an annual limit.
The $10,000 limit is per borrower, not per 529 plan. If a borrower receives $10,000 in 529 plan distributions to repay their student loans and then refinances the remaining debt into someone else’s name (e.g., their spouse’s name), the new loan might be eligible for another $10,000 in qualified distributions, provided that the new borrower has not yet reached the $10,000 limit for their own student loans.
The definition of sibling includes brothers, sisters, stepbrothers and stepsisters.
529 Plans Can Repay Parent Loans Too
The account owner can change the beneficiary to a parent and use this to pay off up to $10,000 of parent education loans too. If each parent has borrowed parent loans, the account owner can change the beneficiary from one parent to the other to pay off that parent’s education loans.
Since the $10,000 limit is 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 the qualified distributions is limited to $10,000 across all education loans.
Not All Student Loan Qualify
The definition of qualified education loan includes all federal loans and most private student loans. But, some private loans do not qualify.
To be considered a qualified education loan, the loan must satisfy these requirements:
- The loan must have been borrowed solely to pay for qualified higher education expenses. Mixed-use loans, such as credit cards and home equity loans, do not qualify. Loans that, in combination with financial aid and other student loans, exceed the cost of attendance do not qualify.
- Loans from retirement plans do not qualify, even if they were used to pay for qualified higher education expenses.
- Loans made by someone who is related to the borrower (defined as brothers, sisters, spouses, ancestors and lineal descendants) are not eligible.
- The loan must have been borrowed within 90 days of the date the college costs were paid. Loans for prior year charges do not qualify.
- The student must have been enrolled on at least a half-time basis during the academic term for which the loan was borrowed. This means that loans made after the student graduates, such as bar study loans and residency & relocation loans, do not qualify.
- The student must have been enrolled in a degree or certificate program. Continuing education loans do not qualify. Loans to pay for dual enrollment programs do not qualify.
- The student must have been enrolled in a college or university that is eligible for Title IV federal student aid.
- Qualified higher education expenses are based on the definition of cost of attendance in the Higher Education Act of 1965 that was in effect on August 4, 1997. Subsequent changes to the definition of cost of attendance, such as the addition of allowances for the purchase of a personal computer and for the cost of obtaining first professional credentials and licensing, do not apply. Any loans that were used to pay for these additional costs are not eligible.
Some States Do NOT Conform To Federal Rules
Some states have not adopted the federal definition of qualified expenses. Accordingly, using a 529 plan distribution to repay student loans may be considered non-qualified by the state even if it is considered qualified by the IRS. The earnings portion of such a distribution may be subject to state income tax. There may also be recapture of any state income tax breaks that are attributable to the non-qualified distribution.
Impact On The Student Loan Interest Deduction
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 qualified distribution from a 529 college savings plan.
The Student Loan Interest Deduction provides taxpayers with an above-the-line exclusion from income for up to $2,500 in interest paid on qualified education loans.
The amount of interest eligible for the Student Loan Interest Deduction is reduced by the earnings portion of the 529 plan distribution that is used to repay the borrower’s qualified education loans.
For example, suppose that a third of the 529 plan distribution comes from earnings. If the beneficiary receives a $10,000 distribution to repay student loans, $3,333 of the distribution will come from earnings. Since $3,333 exceeds $2,500, the borrower will not be eligible to claim the Student Loan Interest Deduction that year.
On the other hand, if only 10% of the distribution was earnings or the distribution amount was just $3,000, eligibility for the Student Loan Interest Deduction would be reduced by $1,000, leaving the borrower eligible to claim up to $1,500 in Student Loan Interest Deduction on their federal income tax return.
The earnings portion of a 529 plan distribution is proportional. Unlike a Roth IRA, the account owner cannot take a distribution of just contributions.
However, if there are multiple 529 plans, the account owner could choose to take a distribution to repay student loans from the 529 plan with the lowest percentage earnings to maximize eligibility for the Student Loan Interest Deduction.
Mark Kantrowitz is an expert on student financial aid, scholarships, 529 plans, and student loans. He has been quoted in more than 10,000 newspaper and magazine articles about college admissions and financial aid. Mark has written for the New York Times, Wall Street Journal, Washington Post, Reuters, U.S. News & World Report, MarketWatch, Money Magazine, Forbes, Newsweek, and Time. You can find his work on Student Aid Policy here.
Mark is the author of five bestselling books about scholarships and financial aid and holds seven patents. Mark serves on the editorial board of the Journal of Student Financial Aid, the editorial advisory board of Bottom Line/Personal, and is a member of the board of trustees of the Center for Excellence in Education. He previously served as a member of the board of directors of the National Scholarship Providers Association. Mark has two Bachelor’s degrees in mathematics and philosophy from the Massachusetts Institute of Technology (MIT) and a Master’s degree in computer science from Carnegie Mellon University (CMU).