529 college savings plans, tax-advantaged college investment accounts, are no longer just for paying for college. In the last few years, the IRS opened up the accounts to be able to be used for K-12 private school education.
Recently, a new rule was made by the IRS to add student loan repayment. Thus, families can now save for and pay off student loans with 529 college savings plans.
While it may not seem to make sense to save for student loans instead of just paying for college expenses, there are circumstances when this new rule would help families out a lot. For instance, your kid decided not to go to college, but you still have your own student loan debt. You can then withdraw money to pay off your student loan debt without paying a tax penalty.
If you’re considering whether taking money out of yours or your child’s 529 plan to pay for student loans, here’s what you need to know:
What a 529 plan is
A 529 plan is a college investment account with an assortment of investment options from savings accounts to mutual funds similar to a 401(k). Plans often offer packages of investments based on age that focus more on stock market-based investments for faster growth when students are further away from college and gradually learn towards safer investments like savings and money market accounts when students get closer to college attendance. The money grows tax free and can be withdrawn tax free as long as it used for a qualified education expense or up to $10,000 in student loan debt. Taxes may be collected after withdrawal for a non education expense plus a federal and sometimes state tax penalty. Some plans also have a perk of guaranteeing future tuition prices.
Any precautions you should take when setting up an account
When opening a 529 plan, the biggest precaution to take is to consider all tax benefits. While you may choose a plan in any state, some states require choosing a plan from your home state in order to get an income tax deduction on money you contribute to the plan. Review your plan options on collegesavings.org and individual 529 plan websites.
What the rules are for withdrawing for student loan debt
As long as the money was withdrawn from the 529 plan after 2018, you can withdraw up to $10,000 from your 529 plan account without paying a tax penalty. The federal tax penalty alone would have been $1,000 plus income tax on the part of the withdrawal that comes from earnings.
In order to withdraw funds tax free, the student loan debt has to belong to the beneficiary or the beneficiary’s sibling. The beneficiary is whomever you listed as the person you are saving for. For instance, you may be savings for yourself, a grandchild, a niece or nephew, or your own child. You can change the beneficiary if you choose to do so. If you are withdrawing for anyone’s loans besides the sibling, this is necessary to not pay the tax penalty.
Whether you should save for student loan debt
It’s generally better to save for college expenses than accumulating and paying for student loan debt. For instance, let’s say you are able to save $15,000 over the course of 10 years to help out with your child’s college expenses. Plan for using that money to go towards tuition and fees, etc. Even if you think you may get a higher return by keeping the money in investments than the interest you’d pay on student loans, it’s not guaranteed.
However, there are a few circumstances when it does make sense to use college savings plan to pay off student loans:
- Your child decides not to go to college. “The number one question we get when parents are deciding whether to open a 529 plan is what happens if my kid decides not to go to college?”, says Betty Lochner, former executive director of Washington State’s 529 plan. Giving families one more option for using 529 plans may make them that much less worried about opening one.
- Sometimes, it may be best for your family’s current financial situation to pay off your student loans and reduce your kids college savings. For instance, you may have a financial hardship and can’t afford your current loans payments. Once your student loan debt is clear, you could afford to save $50 per month for your child’s education. You may also have the leeway to work less hours and save money you’d pay for childcare.
- One sibling needs the money more than the other. You decided to pay for X amount of schooling per child and saved accordingly. You made this decision when your children were young, and you didn’t know what would happen in their lives. One child ends up not needing all the money they saved because of scholarships or going to a less expensive school. The other child has to borrow student loans for part of their education. You can then use the money for the other child’s student loans without anyone a tax penalty.
- The grandparent opened the 529 plan to help their children. Sometimes, even if the grandparent parent paid for their kids’ undergraduate education, there still may be student loans from grad school. The parent may choose to pay off their loans before savings for their kids education, especially since graduate students loans have higher interest rates than undergraduate off paying off those loans and starting fresh on their child’s education savings. If the grandparent owns the 529 plan, they’d need to change the beneficiary’s name to the parent’s name.
Whether you can amend past year’s tax returns
If you already filed your tax return for 2019, you can file an amendment if you paid a tax penalty for withdrawing money from your 529 plan and get a refund. However, the rule doesn’t backdate past 2019. So you can’t amend returns to get a refund if you withdrew money for student loan debt in 2017 or 2018.
Whether there are restrictions based on type of student loan
Luckily, you can withdraw $10,000 to repay student loans, no matter whether they are private student loans or any kind of federal student loan. The only real restriction is the name on the loan. For instance, it doesn’t matter if you cosigned a loan for your student. If the loan is under their name, they are the one who can withdraw the funds for student loans if they are also the beneficiary of the 529 plan account. Beneficiaries of the 529 plan account can be changed, so you may want to do so first if the beneficiary is not the same as the person you want to use the account at that point.
If there is an income requirement
529 plans don’t have income requirements for federal tax benefits, unlike tax credits for higher education or the student loan interest tax deduction. However, remember, you can’t take a tax deduction for student loan interest that is paid off with the 529 withdrawal. That would be considered double dipping on a tax advantage. When calculating how much to deduct for the student loan interest deduction, just subtract the amount of interest your student loan services says was paid off by the payment you made from your 529 plan account.
Bottom line: Part of the design of 529 plans is for the accounts to be able to be switched out among family members as needed. Adding student loans as a withdrawal option increases flexibility for families who need to withdraw the money for this purpose and for families unsure about opening an account in case their child doesn’t go to college.
“The country is struggling under massive student debt, says Lochner. “This is just one way to ease the burden.”
5 Key Takeaways When It Comes To 529 Plans
- $10,000 can now be withdrawn from 529 plan accounts tax free to pay back student loans.
- The loan has to be in the beneficiary’s name. If the student loans are in anyone’s name beside the beneficiary or their sibling, the beneficiary must be changed before the money is withdrawn.
- The beneficiary is the person that the 529 plan account designates as the person who can use the funds. The account owner is the only person who can change the name of the beneficiary.
- While it is possible to save to pay off student loans, the smartest ways to use this option is if something comes up later on where the beneficiary no longer needs the money or someone else in the family needs it more.
- It doesn’t matter how much income anyone makes to avoid the tax penalty. There are also no restriction on the type of loan. Money can be withdrawn for federal or private student loans, as long as the beneficiary is listed as the primary borrower. If the cosigner of the loan took out the funds, they would pay a tax penalty.
