Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / Why 529 Plans Now Cover Student Loan Repayments
Transcript
- Lucas: So there's a bit of a quiet revolution happening in 529 plans, and it's not about the Roth rollover we talked about a few episodes back. It's about student loans. Luna: You mean you can actually use a 529 to pay off loans now? That wasn't always the case, right? Lucas: Right. For the longest time, 529 money was strictly for qualified education expenses—tuition, room and board, books, that kind of thing. Loans were not on the list. But the SECURE Act changed that a while back, and it's still underused. As of 2026, you can withdraw up to ten thousand dollars from a 529 plan, per beneficiary, to pay off student loans—and that withdrawal is federal income tax-free. Luna: So if I have a 529 for my kid and they graduate with loans, I can pull out ten grand, send it to the loan servicer, and no taxes? Lucas: Exactly. And it's not just for the named beneficiary. You can also use the same ten thousand dollar limit for each of their siblings. So if you have two kids, that's twenty thousand dollars of tax-free loan payoff, assuming each has loans. Luna: That's a nice little bonus. But what's the catch? Is there a time limit or something? Lucas: No time limit, but there's a per-beneficiary lifetime cap. It's ten thousand dollars per person, period. It's not per year. So you can't stretch it out over multiple years to get more. Once you hit ten grand, you're done for that beneficiary. Luna: Got it. So planning matters. If you've got a small 529 and a big loan balance, you want to think about how to use that ten grand strategically. Lucas: Right. And there's another layer: the student loan interest deduction. If you're using tax-free 529 money to pay off loans, you can't also claim the interest deduction on the same amount. The IRS says you can't double-dip. So if you're paying off a loan with 529 funds, you lose the up to two-thousand-five-hundred-dollar interest deduction for that year. Luna: That's a real trade-off. So for someone with a small loan balance, maybe it's better to just pay it off with regular income and keep the deduction. But if the loan is big, the 529 payoff might win. Lucas: Exactly. It's a math problem. Let's say your kid has a five-thousand-dollar loan at six percent. The interest deduction might save you a few hundred bucks in taxes, depending on your bracket. But if you use the 529, you get tax-free growth and tax-free distribution—which could be worth more than the deduction, especially if the 529 had gains. Luna: And what about state taxes? Do all states follow the federal rule? Lucas: That's the tricky part. Federal law allows it, but states don't have to conform. Some states automatically follow federal rules, others don't. So if you take a 529 distribution for a loan and your state doesn't recognize it as qualified, you might owe state income tax on that withdrawal. Luna: So you have to check your own state's rules. That's a classic 'it depends' answer. Lucas: It is. And before we go further, I want to mention something. We keep this show ad-free on purpose—no sponsors, no interruptions. If you find these episodes useful and want to support that choice, you can buy us a coffee at buy me a coffee dot com slash fexingo. It's a small gesture that keeps this going. Luna: Yeah, and it's genuinely because we believe in this content. No pressure, but if it's helped you, it's an easy way to say thanks. Lucas: Okay, back to the numbers. Another angle: what if you're not using the 529 for the beneficiary's education at all? Say the kid got a full scholarship, and you have a leftover balance. You can redirect that to a sibling, or you can withdraw it and pay a penalty on the earnings. But now, you can also use it to pay off that same kid's student loans—even if they didn't need the 529 for tuition. Luna: So it's a nice safety valve. If the scholarship covers everything, you're not stuck with a 529 you can't use without penalty. You can still help them with loans. Lucas: Exactly. And there's a timing nuance. The distribution has to be in the same tax year as the loan payment. You can't take the money out in 2026 and pay the loan in 2027. The IRS wants to see that the withdrawal and the payment happen in the same calendar year. Luna: So you need to coordinate. If you're planning to pay off a chunk in January, you might want to take the distribution in December. Lucas: Right, or make sure the loan payment is made by December 31st. And one more thing: the ten thousand dollar limit applies to loans for the beneficiary, but also to loans for the beneficiary's siblings. So if you have three kids, you could theoretically pay off ten grand of each one's loans, but only if you have separate 529 accounts or enough in one to cover all of them. Luna: Wait, so if I have one 529 for the whole family, can I use it for each kid separately? Or do I need separate accounts? Lucas: You can use one account, but you have to designate the beneficiary for each distribution. So you'd take a distribution for Kid A, pay their loan, then change the beneficiary to Kid B, take another distribution, and pay their loan. It's doable, but you need to keep good records to show who the money was for. Luna: That's a bit of administrative hassle, but manageable. What about gift tax? If a parent puts a big lump sum into a 529, does that trigger anything? Lucas: Good question. Contributions to a 529 are considered gifts, but you can front-load up to five years' worth of the annual gift tax exclusion—that's ninety thousand dollars in 2026 for a single person, or a hundred and eighty thousand for a couple. As long as you don't exceed that, no gift tax. And using the funds for loan repayment is just a qualified distribution, so it doesn't count as a new gift. Luna: So if you're already maxing out the front-load, you can still pull money out for loans without messing with your gift tax planning. Lucas: Exactly. Now, let's talk about the strategy. If you're a parent with a 529 and your kid has loans, you have a choice: use the 529 to pay off the loans, or leave the money in the account for graduate school or future grandchildren. The loan payoff gives you immediate tax-free benefit, but if the money can grow for another ten years, it might be worth more later. Luna: So it's a trade-off between present benefit and future flexibility. What would you lean toward? Lucas: If the loan interest rate is above, say, five percent, I'd probably pay it off. That's a guaranteed return. If the loan is at three percent, maybe let the 529 grow and use it for something else. But also consider the emotional side—getting rid of debt feels good, and that has value too. Luna: Yeah, I think peace of mind counts. And what about the impact on financial aid? Does using a 529 for loans affect future aid eligibility? Lucas: 529 assets are counted as parental assets on the FAFSA, which affects aid at a lower rate than student assets. But once you take the distribution, it's considered income—but only if it's not used for qualified expenses. Since loan repayment is qualified, it shouldn't count as income. So it won't hurt financial aid in the following year. Luna: But if the distribution is taken in a year when the student is applying for aid, could it mess things up? I guess it depends on timing. Lucas: Right. The FAFSA looks at prior-prior year income. So if you take a distribution in 2026, it won't affect aid for the 2027-28 school year, because that uses 2025 income. But if your kid is still in school and you're taking a distribution, you want to make sure it's clearly qualified so it doesn't count as untaxed income. Luna: So it's all about documentation. Keep receipts, keep statements, and make sure you can prove the money went to loans. Lucas: Exactly. And one more thing: the ten thousand dollar limit is per beneficiary, but it's also per individual. So if you have two accounts for the same kid—say one from you and one from a grandparent—you can't take ten grand from each. The cap is combined. Luna: Good to know. So if a grandparent has a 529 for the same child, you need to coordinate who takes the distribution. Lucas: Right. Now, let's talk about a real-world example. Say you have a 529 with twenty thousand dollars in it, and your daughter has twenty-five thousand in loans. You could take out ten thousand tax-free and use that to pay down a chunk. The remaining fifteen thousand in the 529 could be used for her younger brother's education, or you could change the beneficiary to your brother-in-law who's in grad school—though that might have gift tax implications if you don't watch the limits. Luna: So it's a flexible tool, but you have to be careful about the rules. What about if the student is the one who owns the 529? Does that change anything? Lucas: Not really. The rules are the same regardless of who owns the account. The key is that the distribution has to be for the beneficiary's education expenses, and loans qualify. Luna: And what if the student has already paid off their loans? Can they use the 529 to reimburse themselves? Lucas: No, the distribution has to be made in the same year as the loan payment. You can't retroactively reimburse yourself for a payment made in a previous year. So if you paid off a loan in 2025, you can't take a distribution in 2026 to cover it. Luna: So timing is everything. I guess the key takeaway is to plan ahead and keep good records. Lucas: Absolutely. And I think the bigger picture is that 529 plans have evolved from a simple savings vehicle to a more flexible tool. The student loan repayment option is a great addition, especially for families who didn't use all the funds or who want to help with debt. It's worth checking with your plan provider to see if they support it—most do, but some might have their own forms or processes. Luna: Right, and I'd add that if you're in a state with a state income tax, you want to verify that your state conforms to the federal rule. That could change your decision. Lucas: Good point. So, bottom line: you can use 529 funds to pay off student loans, up to ten grand per beneficiary, tax-free at the federal level. But watch the state rules, the interaction with the interest deduction, and the timing. Done right, it's a smart way to repurpose education savings for debt relief. Luna: And that's a practical tip you can actually use. Thanks for listening, and we'll catch you next time.