Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plans and Student Loan Refinancing Strategies
Transcript
- Lucas: Alright, so we've talked about using 529 plans for everything from K-12 tuition to coding bootcamps. But there's one use case I think a lot of families miss, even though it's been allowed for a couple years now: student loan refinancing. Luna: Right. The SECURE Act 2.0, which passed back in late 2022, let 529 plans cover up to $10,000 in qualified student loan repayments. But refinancing is a slightly different animal. Lucas: Exactly. The law says you can take a penalty-free distribution from a 529 plan to pay principal or interest on a qualified student loan of the beneficiary or a sibling. That includes refinanced loans. So if your kid graduates with, say, $40,000 in private loans at 7 percent, and they refinance to 4.5 percent, you can use the 529 to pay down that refinanced loan. Luna: But there's a catch, right? The $10,000 limit is per beneficiary, not per loan. And it's a lifetime limit. Lucas: That's right. So if you have two kids, you can use $10,000 for each. But for a single child, you're capped at $10,000 total. That said, it's still a nice chunk of change if you've got a 529 balance left over after graduation. Luna: Or if you've been contributing aggressively for years and your kid gets a scholarship. I've heard from listeners who end up with more in the 529 than they need for tuition. Lucas: Yeah, that's actually the most common scenario we hear about. So the question becomes: should you use that leftover money to pay off student loans directly, or refinance first and then pay? There's a nuance there. Luna: Walk us through it. Lucas: Okay, say your daughter graduates with $30,000 in federal loans at 5.5 percent. She refinances with a private lender to 3.5 percent. Now you can take $10,000 from her 529 to pay down the refinanced loan. But here's the thing: if those were federal loans, refinancing means losing access to income-driven repayment plans and potential forgiveness programs like Public Service Loan Forgiveness. Luna: So refinancing federal loans just to use a 529 could backfire if she ends up in a lower-paying job. Lucas: Exactly. The 529 loan repayment provision is really best suited for private student loans, or for federal loans where you're confident you won't need those protections. That's the first thing to check. Luna: Makes sense. I had a listener in Ohio whose daughter graduated from law school with $150,000 in private loans at 6.8 percent. They had about $12,000 left in a 529. They refinanced the entire loan to 4.2 percent, then used the 529 to pay $10,000 toward it. Saved about $3,200 in interest over the life of the loan. Lucas: That's a great example. And the key there is they refinanced first to lock in a lower rate, then used the 529 to pay down principal. The order matters because the 529 distribution is based on the loan balance at the time of payment. Luna: Right. If you take the 529 money first, then refinance, you're refinancing a smaller balance but you might not get the same rate. Lenders often have minimums. Lucas: Precisely. So the playbook is: refinance first if it makes sense, then use the 529 to pay down the new loan. One more wrinkle: state tax treatment. Not all states conform to the federal rules. Luna: Meaning some states might treat the withdrawal as a non-qualified distribution and recapture the state tax deduction you took on contributions. Lucas: Exactly. For example, California and New Jersey don't conform to the federal provision. So if you live there, using a 529 for loan repayment could trigger state income tax and a 2.5 percent penalty on the earnings portion. You'd want to check your state's rules before pulling the trigger. Luna: That's a potential gotcha. But if you're in a state that does conform, like New York or Illinois, it's straightforward. Lucas: Right. And let's not forget the Roth IRA rollover option that came along in 2024. Starting in 2024, you can roll over up to $35,000 from a 529 to a Roth IRA for the beneficiary, subject to annual contribution limits. So if you have leftover funds and the child doesn't have much loan debt, that might be a better move. Luna: Yeah, the Roth rollover is attractive because that money grows tax-free for retirement and you never pay taxes on withdrawals. But the 529 must have been open for at least 15 years, and the rollover counts toward the annual Roth contribution limit. Lucas: So you're essentially choosing between paying down debt today or giving your kid a head start on retirement savings. Both are good problems to have. Luna: I think a lot of parents don't realize they have these options. They assume leftover 529 money is either locked up or subject to penalties. Lucas: Yeah, that's the old rule. Before 2019, you could only withdraw leftover funds for other qualified expenses or take a non-qualified withdrawal with a 10 percent penalty on earnings. The SECURE Act changed that, and 2.0 expanded it further. Luna: So let's talk about a concrete scenario. Parents have $25,000 left in a 529 after their son graduates with no debt. What do they do? Lucas: First, check if there's a sibling who could use it. You can change the beneficiary to another family member without penalty. If not, the Roth rollover is an option — up to $35,000 total, but the 529 must be at least 15 years old. If it's not, you could wait. Or you could just keep the money in the 529 for future grandkids. Luna: That's a long time horizon though. The account can stay open indefinitely, but if the beneficiary is 30 and not planning more school, it might sit for decades. Lucas: Right. So another option: if your state allows it, use up to $10,000 for student loan repayment of the beneficiary's siblings. Or even a spouse — the definition of 'family member' is broad. Luna: And if none of those work, you could always withdraw the money, pay taxes on the earnings, plus the 10 percent penalty. But that's usually the last resort. Lucas: Yeah, the penalty is only on earnings, not on contributions. So if you contributed $20,000 and it grew to $25,000, you'd pay ordinary income tax plus 10 percent on the $5,000 gain. That's not terrible, but it's not ideal either. Luna: I think the key takeaway is that families should think about 529 funds as part of a broader financial plan, not just a tuition account. Lucas: Speaking of thinking ahead, if this conversation helped you think about your own 529 strategy differently, that's the kind of thing that makes this podcast worth doing. And if it was worth a coffee to you, you can find us at buy me a coffee dot com slash fexingo. Luna: We keep the show ad-free, and listener support is what makes that possible. Every bit helps us keep digging into these topics. Lucas: Alright, back to it. One more nuance I want to hit: the timing of the 529 distribution for loan repayment. The IRS says the distribution must be made in the same tax year as the loan payment. So you can't take money out in 2025 to pay a loan in 2026. Luna: So you need to coordinate. If you're paying monthly, you could take one lump sum and pay down a chunk, then make the remaining payments normally. Lucas: Exactly. And keep records — the 529 plan will send you a Form 1099-Q, and you'll need to report the distribution on your tax return. The loan servicer should provide a statement showing the qualified education loan interest paid. Luna: That's a good reminder. Documentation is key because if the IRS ever asks, you want to show the loan was qualified. Lucas: One more thing: the $10,000 lifetime limit applies to the beneficiary, not the account owner. So if you have multiple 529 accounts for the same child, you can use a total of $10,000 across all of them. Luna: And that $10,000 is per individual, not per loan. So if your child has both federal and private loans, you can still only use $10,000 total. Lucas: Right. But if you have two children, that's $20,000 total you can deploy toward their loans. Not a life-changing sum, but meaningful for many families. Luna: I think it's also worth mentioning that the 529 can be used to repay Parent PLUS loans. Those are loans taken out by parents, but they're still qualified education loans under the law. Lucas: Yes, that's a great point. If a parent took out a PLUS loan for their child, the 529 can pay that too, as long as the child is the beneficiary of the 529. It's a bit of a roundabout, but it works. Luna: So the bottom line: if you have a 529 with leftover funds and your child has student loans, don't just let the money sit. You have options, but you need to check state rules and think about refinancing first. Lucas: And if your child has no loans, consider the Roth rollover or keep the account for future family members. The flexibility is there now more than ever. Luna: Alright, that's a solid episode. Thanks for joining us. Lucas: Yeah, thanks Luna. And to our listeners — we'll be back next time with another angle on making your education dollars work harder.