Can I Use A 529 To Repay Student Loans?

A question that often gets asked is if 529 accounts can be used to repay student loans. Technically the answer is yes, but there are major drawbacks in doing so.

You can use a 529 account to pay for tuition, fees, room and board, books, computers, and other “qualified” education expenses without tax implications or penalties.

However, student loan payments are not considered qualified expenses.

The earnings on non-qualified withdrawals are subject to federal income tax and may be subject to a 10% federal penalty tax, as well as state and local income taxes. Also, many states have a recapture or “clawback” provision that will make you pay back any tax breaks you received.

PRO TIP: If a non-qualified distribution occurs from a 529 account, the tax credit recapture is assessed to the owner of the account regardless of who actually contributed the funds and received the original credit (e.g., grandparents have been contributing to the account and claiming the credit but you own the account, you are liable for the recapture).

What if the rules change?

Earlier this year, the House Ways and Means Committee unanimously passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act.

While not official yet, the legislation does propose expanding the benefits of 529 college savings plans, including adding principal and interest payments toward student loans as qualified education expenses — up to a lifetime limit of $10,000 per 529 plan beneficiary.

This would be a huge benefit for parents who have leftover money in their child’s 529 accounts after they have already graduated.

Families in this situation now only have two options:

  1. transfer the funds to other children or another family member to use for qualified education expenses, or
  2. accept the tax liability for non-qualified withdrawals.

Having the flexibility to use the 529 accounts for student loans payments would not only increase the 529’s utility for families in this unique situation but even independent, working adults who still have student loans.

Strategy for independent adults

If you’re an independent taxpayer (meaning you can’t be claimed as a dependent on anyone else’s tax return) you can deduct interest on student loans paid by you, or by your spouse if you file a joint return.

Like many tax breaks, the student loan interest deduction is designed to provide tax relief to Americans with low to moderate incomes.

The ability to take the deduction begins to phase out above a certain MAGI (modified adjusted gross income) level.

Phaseout thresholds for the 2019 tax year.

If your MAGI is under the threshold where the phase-out begins, you can deduct up to $2,500 in student loan interest or the actual amount of interest you paid, whichever is less.

PRO TIP: The deduction is capped at $2,500 in total interest per return, not per person, each year. In other words, if you’re single, you can deduct as much as $2,500 of student loan interest. However, if you’re married and file a joint return, you and your spouse can only deduct a total of $2,500, even if both spouses have student loan debt.

If you earn between $70,000 and $85,000 as a single filer or between $140,000 and $170,000 as a joint filer, you’ll qualify for a reduced amount of interest deduction less than $2,500. 

Unfortunately, your student loan interest isn’t deductible at all if your income is more than the ceiling where the phase-out ends. 

While the student loan interest deduction can be very valuable (if you even qualify for it) it’s possible that your state offers a tax incentive for contributing to a 529 plan that is more beneficial than the interest deduction. 34 states currently offer a state tax credit or deduction for contributions to a 529 plan.

Depending on the tax benefit your state is offering, it could make sense to fund a 529 account, earn the tax benefit, and then use the 529 account to pay your student loans.

PRO TIP: There are no age restrictions for 529 accounts which means anyone over the age of 18 can open a 529 and name themselves the beneficiary.

You can generally claim a state tax benefit no matter how long the money is held in your 529 plan. So instead of paying tuition straight from a bank account, you can funnel the money through a 529 plan in order to claim the tax benefit.

Hypothetical example

Let’s assume you’re an Indiana resident and your student loan payments equal $5,000 per year, $2,500 of which is interest.

Indiana taxpayers (resident or non-resident, married or individual) are eligible for a state income tax credit of 20% of contributions to a CollegeChoice 529 account, up to $1,000 credit per year.

You can either pay the $5,000 student loan payments out of pocket and claim the $2,500 interest deduction on your Federal return or use the 529 account strategy to claim a tax credit on your Indiana return.

PRO TIP: Tax code prohibits double-dipping when it comes to claiming multiple credits or deductions for the same expenses in a single year, so student loan interest payments made using a 529 account will not be eligible for the student loan deduction.

Very simplified, very hypothetical, use for illustrative purposes only.

Based on our example, using the 529 plan to funnel the student loan payments through saved an additional $450 in taxes. Not too shabby!

The potential tax savings would be even greater in a scenario where the person was above the income threshold for the interest deduction, as 529 plans don’t have income limits and even the highest earners can contribute and receive available tax benefits.

While this strategy is purely hypothetical right now, I do think it has merit if the SECURE Act becomes law.

I will definitely be keeping my eye on the progress of the bill!