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!

The Basics of a Credit Score

Your credit score is a three-digit number that lenders use to determine whether or not you are a trustworthy borrower.

Many lenders use the Fair Isaac Corporation (FICO) model for credit scores, which grades borrowers on a point range, with a higher score indicating less risk to the lender and a more favorable rate for you.

Take for example this credit savings illustration available at myFICO.com.

Borrowers with excellent credit scores — between 720 and 850 — save as much as $9,601 in interest over the life of a 60-month, $25,000 car loan compared to borrowers with scores ranging from 500 to 589. That is real money saved!

While the above example shows the effect of differing FICO scores on a hypothetical auto loan, the same principle applies to any other line of credit — credit cards, personal loans, mortgages, etc.

That’s why it’s important to know what factors are taken into consideration when calculating your credit score so you can take proactive steps in building good credit and qualifying for the lowest rates possible.

Payment History

Repaying past debts is the largest factor that makes up your credit score. Payment history amounts to 35 percent of your score and includes both revolving credit, such as credit cards, and installment loans, like mortgages. In short, payment history is used in credit formulas to determine future long-term payment behavior. Making on-time payments is one of the best ways to improve or maintain a high score.

Amounts Owed

The amounts owed factor accounts for 30 percent of your credit score. The formulas used to compute scores tend to see borrowers who reach or exceed their credit limit as a higher risk. Keeping card balances low can positively impact your score. Utilizing a high percentage of available credit will do just the opposite.

Length of Credit History

Opening a credit account early can pay off in the long run. The length of credit history factor, specifically the age of your first account, makes up 15 percent of your credit score. As time goes on, account holders with a positive history will have more data that influences their credit report.

New Credit

New credit amounts to 10 percent of your credit score. Opening new credit accounts on a whim can negatively impact your financial health, as it is a sign of greater risk. A 20-percent store discount for opening a new credit account may sound great, but it could make getting a loan, or a lower interest rate, more difficult. Only open new credit accounts when necessary to give your score a small boost.

Credit Mix

The fifth and final factor that contributes to your financial health is your credit mix. Credit mix is comprised of the various accounts you currently have open. This can include but is not limited to, credit cards, installment loans, and finance company accounts. Credit mix makes up the final 10 percent of your overall credit score.

Knowing the factors that affect your credit score can help you build and maintain a high credit score which will allow you to borrow from lenders at lower rates, saving you money in the long run.

If you are using credit cards to build credit, make sure you are using your available credit wisely, paying off the balances at each cycle, and only opening new lines of credit when absolutely necessary.

What Are The Different Types of Life Insurance?

There are two basic types of life insurance, term and permanent. 

Depending on your age, health, and overall financial goals you need to weigh the benefits of both before deciding which type of insurance to purchase.  You may only need one type or you may need both.

Understanding what each has to offer is key in making a sound decision.

Term Life Insurance

  • Term insurance only pays a benefit as a result of death within the term period.  The term period usually ranges from one to thirty years.
  • There are two types of term insurance, level term and decreasing term.
  • Level term means that the death benefit will remain the same throughout the existence of the policy.
  • Some level term policies may contain an increasing benefit rider, which increases the death benefit each year over the course of your term.  You will, however, agree to pay slightly higher premiums each year as well.
  • Decreasing term means that the death benefit is steadily reduced, usually in one-year increments, throughout the existence of the policy.
  • Term conversion options are included in many term life insurance policies which allow you to convert to a permanent form of insurance, like whole life.
  • The years in which you can convert — and the products you can convert to — will vary depending on the specific policy and carrier.

Permanent Life Insurance

  • Permanent life insurance does not expire, hence the name. It will pay a death benefit no matter when you die.  It does not limit you to a term period.
  • There are four types of permanent life insurance: traditional whole life, universal, variable, and variable universal.
  • In a traditional whole life policy, the death benefit and premium stay “level” throughout the life of the policy.  This means that a higher than needed premium is paid in the early years to offset the cost of benefits in the later years.  Basically, the “overpayments” are invested to cover the death benefits of older policyholders.  Companies are legally bound to adhere to the limitations of these “overpayments.”  Once they reach a certain amount, the money becomes available to the policyholder if they choose not to maintain the policy until death.  Essentially, it is like having a savings account.
  • A universal policy has its own key characteristics.  You may be able to increase your death benefit if you pass a medical exam.  The cash value account or “savings account” earn interest at a money market rate.  Once you have enough money in your cash value account you may be able to adjust your premium payments.
  • A variable policy allows you to invest your death protection and cash value in stocks, bonds, and mutual funds.  You have the opportunity to grow your policy quickly.  You also, however, assume more risk and may end up with a decreased benefit or cash value.
  • The variable universal policy combines the principles available in both universal and variable policies.  You can adjust premiums and death benefits like you can with universal, but you can also invest aggressively with the potential for greater rewards as with variable.

Educating yourself and understanding the life insurance options that are available is the first step.  Next, you will need to examine your own family structure and financial goals to determine which policy will be best for you and your loved ones.

A financial advisor can help you determine which life insurance is right for you.

Writing a Sympathy Letter

Writing a sympathy letter can be difficult because often times we feel awkward addressing such a serious matter, or we worry about saying the wrong thing. It can be tempting not to say anything at all and let our insecurities get the better of us.

In my experience, people would rather hear from you than not. They may not consciously be thinking that they need your support, but your words can be uplifting in a time that they really need it. Even the slightest reminder that you are thinking about them during their hard time will help them through it.

To-Do’s of Writing a Sympathy Note

Just write one. The first suggestion about sympathy letters is to always err on the side of writing one. It doesn’t matter if you knew the person they lost well or not at all, go ahead and take the time to send a letter. It’s better to share sympathies in a letter as opposed to bringing it up to the person because sharing sympathies in public can bring up all of the grieving person’s feelings at a time when they’d rather remain composed. A letter, on the other hand, can be reviewed and appreciated in private.

KIS – Keep it simple. Your grieving friend just wants to know that you’re thinking of them, so don’t feel like you have to come up with a profound statement about death and life.

Relive a memory. Sharing a memory of the deceased person gives your grieving friend a few moments to relive special memories of their loved one and lets them know that others have fond memories of that person too.

Don’t compare your losses. This is especially true if you haven’t experienced the exact same thing. If you have experienced a similar loss, a reference to your ability to truly sympathize is appropriate. But don’t go on and on about how you felt during that time; the focus should remain on the other person.

Don’t try to justify the loss. Don’t deliver platitudes like “This is God’s plan,” or “He is better off now,” This will not offer your friend any condolences, even if it may be true.

Express your support. Let them know that you’re thinking and praying for them. Simply saying, “My thoughts go out to you during this difficult time”, is sufficient.

Offer your help. Let the person know that if there is anything you can do for them or if they ever want to talk or hang out, to please let you know.

Example:
Dear Mitch-

I was so sorry to hear about the death of your father, Frank. I remember when we would go fishing, he’d always be telling us tales of past fishing glories. He was definitely a great guy to be around and was always making me laugh.

I am thinking and praying for you every day. If you ever want to talk, don’t hesitate to let me know.

With Deepest Sympathy,

—

If you or someone you know has suffered a loss recently, you may find my piece on loss and having a plan helpful.

ABLE Account or Special Needs Trust

If you want to give assets to a loved one with a disability either during your lifetime or through your estate, you must plan carefully.

Otherwise, you could jeopardize their ability to qualify for public benefits (Supplemental Security Income and Medicaid).

While owning a house, car and other personal property does not negatively affect their benefits, most financial assets, including cash in the bank, will disqualify them from receiving benefits. And the current cap in order to qualify for public benefits is a mere $2,000!

Fortunately, there are ways you can leave assets to a family member with a disability while preserving their eligibility for Medicaid and other assistance.

SPECIAL NEEDS TRUST

A Special Needs Trust (SNT) is the most well-known strategy for helping a loved one with a disability while ensuring they continue to qualify for public benefits. This works because assets are left to the trust, not the disabled family member.

Within the trust document, you will appoint a trustee who will have complete discretion over the trust assets and will be in charge of spending money on your disabled family member’s behalf.

The trustee cannot give money directly to your loved one — that could interfere with eligibility for public benefits — but the trustee can spend trust assets to buy a wide variety of goods and services for them.

Special Needs Trust funds are commonly used to pay for personal care, vacations, home furnishings, out-of-pocket medical and dental expenses, education, recreation, vehicles, and physical rehabilitation.

529 ABLE ACCOUNTS

The ABLE Act was signed into law in 2014, creating 529 ABLE (529A) accounts to provide a tax-advantaged vehicle for saving assets for disabled individuals.

The accounts are sponsored by states, but there are no residency requirements to enroll. Some states offer tax deductions for contributions but amounts and rules vary.

ABLE accounts can be created and managed by the beneficiary, subject to capacity. If they need assistance, the account can be established and/or managed by their parents, conservator/guardian or agent under a power of attorney.

Money in the ABLE account (up to the first $100,000) will not be subject to the $2,000 personal asset limit that determines eligibility for public benefits.

Another major benefit of the 529A account is its taxation. Unlike a Special Needs Trust, money coming out of a 529A account is tax-free if it’s going toward a qualified disability expense.

Qualified disability expenses include basic living expenses, housing, education, transportation, employment training and support, and health care prevention and wellness — but does not include supplemental expenses such as vacations or personal grooming.

Something to be aware of is that if the money in the 529A is used for non-qualified disability expenses, the earnings portion of the withdrawal would be subject to regular income tax and a 10% penalty.

In those states that have adopted special state income tax benefits, non-qualified withdrawals might also incur additional state tax penalties.

Which to Choose?

One of the primary aims of the ABLE program was to provide a solution for disabled individuals who do not have the support structure and financial means to create a Special Needs Trust.

ABLE accounts are a less expensive alternative to a Special Needs Trust as the fees are nominal — generally limited to maintenance and charges by financial institutions.

There are also several circumstances in which an ABLE account may be particularly useful. For example, an ABLE account would allow an individual with disabilities to save unspent work earnings or Social Security benefits for a future purchase without violating the general rule that the recipient of SSI and Medicaid cannot accumulate more than $2,000.

However, for most individuals with disabilities, an ABLE account is not a substitute for comprehensive Special Needs Trust planning.

Since they each have their own nuances that seem to pair well the other, the 529A and Special Needs Trust should be used side-by-side for families with disabled children and adults.

For example, a carefully drafted SNT can authorize the trustee to transfer money into the beneficiary’s ABLE account to maximize the benefits of both tools simultaneously.

Obviously, when trying to decide whether to establish a Special Needs Trust or an ABLE account, you should consult a special needs planning attorney about the suitability of these savings tools based on your own circumstances.

For help finding a special needs planning attorney, visit https://www.specialneedsalliance.org/find-an-attorney.