Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plans Can Now Pay Student Loan Bills Up to the Limit
Transcript
- Lucas: Luna, here's a scenario I hear from listeners all the time: someone saved diligently in a 529 plan for their child, the child got a scholarship, graduated with honors, and now there's maybe twelve, fifteen thousand dollars left in the account. But the graduate is sitting on thirty thousand in federal student loans. Can that leftover 529 money be used to pay down the debt? Luna: It feels like it should be allowed, right? That money was meant for education. The loans are education debt. Lucas: Right, and since the SECURE Act of 2019, the answer is yes — with important limits. The IRS allows a 529 plan to make a qualified distribution for the beneficiary's student loan repayment, up to a lifetime limit of ten thousand dollars per beneficiary. That's ten thousand total, not per year. Luna: So if you have three kids, each can get up to ten thousand in loan payments from their own 529 plan. That's thirty thousand total across the family. Lucas: Exactly. And it applies to both federal and private student loans. But the key word is 'qualified distribution' — that means the loan repayment is treated like any other qualified education expense. So the earnings portion of the distribution comes out tax-free, and there's no ten percent penalty. Luna: That's huge. Because normally if you take money out of a 529 for something that isn't a qualified expense, you pay income tax on the earnings plus a ten percent penalty. This carves out a specific exception. Lucas: It does. And it's retroactive in a sense — the rule applies to distributions made after December 31, 2018. So if your child graduated in 2020 and you already made some loan payments from a 529, you can go back and amend your tax return to treat those as qualified distributions. Luna: But the ten thousand dollar limit is per beneficiary, not per account. So if a grandparent has a 529 for a grandchild and the parent also has a 529 for the same child, together they can only distribute ten thousand total for that child's loans. Lucas: That's correct. The limit follows the beneficiary, not the account owner. So coordination between family members is critical. If the grandparent distributes five thousand, the parent can only distribute five more for that same child. Luna: What about siblings? Say one child has loans and the other doesn't. Could you change the beneficiary of the leftover 529 to the sibling with loans and then use the funds? Lucas: Yes, that's a common strategy. You can change the beneficiary to another family member — a sibling, a cousin, even a parent — and then the ten thousand dollar limit resets for that new beneficiary. But there's a catch: the beneficiary change must be done before the distribution. And if you change the beneficiary to someone in a lower generation, like from a child to a grandchild, there could be gift tax implications. Luna: So the order matters. First change the beneficiary, then take the distribution for loan repayment. Don't take the distribution and then try to change the beneficiary afterward. Lucas: Exactly. And there's another wrinkle: the ten thousand dollar limit is per beneficiary, but it applies to all 529 plans for that beneficiary combined. So if a student has multiple 529 accounts from different relatives, the total loan repayment from all of them can't exceed ten thousand. Luna: Let's talk about state taxes. Because some states offer a deduction or credit for 529 contributions, but then they might treat the loan repayment distribution differently. Lucas: This is where it gets messy. For federal purposes, it's tax-free. But states have their own rules. Some states, like Arizona and Kansas, follow the federal treatment and consider loan repayments as qualified distributions. Others, like California, do not. California treats the earnings portion of a loan repayment distribution as non-qualified, meaning you'd owe state income tax on the earnings, though no penalty. Luna: So a California resident with a 529 could still use it for loan repayment, but they'd need to report the earnings as income on their state return. That's a pain. Lucas: It is. And it's not just California. A few other states also have unfavorable treatment. The lesson: check your state's specific 529 rules before making a large loan repayment distribution. Most states have a FAQ page or you can call the plan administrator. Luna: What about the beneficiary's own tax situation? If a parent makes a loan payment directly from the 529 to the lender, does the beneficiary have to report anything? Lucas: Generally, the distribution is reported to the IRS on Form 1099-Q, which goes to the account owner — the parent, in this case. But the beneficiary's student loan interest deduction could be affected. Normally, you can deduct up to two thousand five hundred dollars of student loan interest on your federal return. If a third party pays your loan, the IRS considers that as if you received the money and paid it yourself. So the beneficiary can still claim the interest deduction for the amount paid, but only if they meet the income limits and other requirements. Luna: So the parent's 529 distribution doesn't automatically disqualify the child from the student loan interest deduction. Good to know. Lucas: Right. And there's a special rule for 529 loan repayments: the ten thousand dollar limit is per beneficiary, but it applies separately to each borrower. So if a parent and child are co-borrowers on a Parent PLUS loan, can the 529 be used? Luna: That's a good question. Parent PLUS loans are taken out by the parent, but the beneficiary of the 529 is typically the child. Can you use the child's 529 to pay the parent's loan? Lucas: The IRS says yes, as long as the loan is for the beneficiary's education. So a Parent PLUS loan qualifies, even though the parent is the borrower. But the ten thousand dollar limit still applies to the beneficiary — so you can use up to ten thousand of the child's 529 to pay down a Parent PLUS loan. That's a huge benefit for families who used PLUS loans to cover gaps. Luna: So for a family with two children, each with a 529, you could pay up to twenty thousand in Parent PLUS loans — ten thousand per child. Lucas: Exactly. And that's per beneficiary, so if you have three kids, you could use up to thirty thousand. But you have to be careful about the ownership of the 529. If the parent is the account owner and the child is the beneficiary, the distribution is straightforward. If the grandparent owns the account, different rules might apply for financial aid purposes. Luna: Right, because grandparent-owned 529s used to be treated differently on the FAFSA. But that changed with the FAFSA Simplification Act starting in 2024-2025. Distributions from grandparent-owned 529s are no longer counted as income for the student. Lucas: That's correct. And that makes grandparent-owned 529s even more attractive for loan repayment, because the distribution won't affect the student's aid eligibility. So if a grandparent wants to help pay down a grandchild's loans, they can take a distribution from their 529 and it's tax-free up to ten thousand, and it doesn't show up as income on the FAFSA. Luna: Let's talk about recordkeeping. What should listeners keep if they use a 529 for loan repayment? Lucas: You want a paper trail. Keep the loan statements that show the amount paid, the lender's name, and the date. Also keep the 529 distribution statement from the plan. If the IRS ever questions it, you need to prove that the distribution was used for qualified student loan repayment. And remember, the distribution must be made to the borrower or directly to the lender. If you take the money out of the 529 and then write a check to your child, that's fine, but the child must use it for loan repayment. The IRS will look at the ultimate use. Luna: One more question: what if the beneficiary has already used up their ten thousand dollar limit? Can the account owner change the beneficiary to themselves and then use the 529 to pay their own student loans? Lucas: Yes, you can change the beneficiary to yourself — as long as you are a family member of the original beneficiary. That includes the account owner. So if a parent changes the beneficiary to themselves, they can then take up to ten thousand in loan repayments for their own student loans. The lifetime limit follows the new beneficiary — the parent — so they get their own ten thousand. Luna: That's a clever way to repurpose leftover 529 funds. Especially for parents who deferred their own loans while saving for their kids. Lucas: Exactly. And it's worth noting that the ten thousand dollar limit is per beneficiary, not per account. So if you have multiple 529 accounts, you can't double dip for the same person. But you can strategically move funds between family members to maximize the total loan repayment across the family. Luna: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many episodes. If our money conversations have helped you think about a decision differently, that's the kind of support that keeps it going without ads. Lucas: Yeah, it's a small group, but it makes a real difference. And we appreciate it. Now, back to the numbers — let's say you have a 529 with fifteen thousand dollars left and a graduate with twenty-eight thousand in federal loans. You could use ten thousand for loan repayment, tax-free. The remaining five thousand could stay in the account for future education expenses, like if the child goes to grad school, or you could change the beneficiary to a sibling. Luna: And if the child doesn't go to grad school and there's no sibling, you could also take a non-qualified distribution on the remaining five thousand. You'd pay income tax on the earnings, but no penalty if the earnings are offset by a scholarship? Actually, no, that's a different rule. Lucas: Right, the scholarship exception allows you to take a distribution equal to the scholarship amount without penalty, but you still pay tax on the earnings. So if the child got a ten thousand dollar scholarship, you could take ten thousand out penalty-free, but you'd owe income tax on the earnings portion. That's separate from the student loan rule. Luna: So the student loan rule is really the most flexible option for leftover 529 money if the beneficiary has any kind of student debt. Lucas: I think so. It's one of the best uses of excess 529 funds because it avoids both tax and penalty, and it directly addresses the biggest financial burden for many graduates. The key is to plan ahead — know the ten thousand dollar limit, coordinate with other family members, and check your state's treatment. If you do that, you can stretch your 529 savings even further. Luna: And if listeners want a deeper dive on state-by-state rules, we'll link to a resource in the show notes. For now, the takeaway is: yes, you can use a 529 to pay student loans, up to ten thousand per beneficiary, tax-free at the federal level. Check your state, keep records, and consider beneficiary changes to maximize the benefit. Lucas: Well said. That's all for this episode of The College Savings Podcast. We'll be back next time with another specific angle on saving for education.