Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plans as a Student Loan Repayment Strategy
Transcript
- Lucas: So you've been socking money into a 529 plan for years. Your kid gets a great scholarship, or decides on a cheaper school, and suddenly you've got maybe 20, 30, even 50 thousand dollars sitting there with no tuition bill to apply it to. Luna: Right — the classic overfunding problem. And for a long time, your only real option was to either change the beneficiary or eat the penalty on a non-qualified withdrawal. Lucas: Exactly. But there's actually a third option that a lot of families don't know about, and it's been on the books since the Tax Cuts and Jobs Act of 2017. You can use leftover 529 funds to pay down your child's student loans. Luna: Wait — you can use a 529 plan to repay student loans? I thought 529s were strictly for future education costs, not past ones. Lucas: That's the common assumption. But the law changed back in 2018. Under Section 529 of the tax code, student loan repayment is now a qualified expense — up to a lifetime limit of ten thousand dollars per beneficiary. Luna: Ten thousand per beneficiary — so if you've got two kids, that's twenty thousand total that can come out tax-free for loan repayment? Lucas: That's right. And importantly, that ten thousand dollar limit applies per individual, not per 529 account. So if a grandparent also has a 529 for that same child, the combined distributions for loan repayment can't exceed the ten thousand dollar cap. Luna: Got it. So it's a per-beneficiary lifetime cap. And the money comes out federal-income-tax-free, as long as it goes toward the beneficiary's qualified student loans. Lucas: Exactly. The loan has to be in the beneficiary's name — so you can't use it to repay your own student loans from a 529 you set up for yourself, unless you're the beneficiary. And the distribution is tax-free only up to that ten thousand dollar limit. Anything beyond that is treated as a non-qualified withdrawal, subject to income tax plus the 10 percent penalty on earnings. Luna: So the penalty still applies if you try to pull out more than ten grand for loan repayment. That's a pretty hard ceiling. Lucas: It is. But for a family with an overfunded 529, that ten thousand can be a meaningful chunk. And it's a much better outcome than taking a non-qualified withdrawal on the full amount. Let's run through a concrete example. Luna: Please. I think listeners learn best from real numbers. Lucas: Let's say you're in New York, and you opened a 529 for your daughter when she was born. You contributed $250 a month for 18 years. With investment growth, the account is worth about $50,000 by the time she's ready for college. Luna: Nice — that's a solid nest egg. Lucas: But your daughter gets a partial scholarship that covers most tuition, and she chooses a state school with low room and board. After four years, there's about $25,000 left in the 529. You've got a few choices. Luna: Option one: leave it in the account for a future grandchild. Option two: change the beneficiary to another child. Option three: take a non-qualified withdrawal and pay the penalty. And option four: use up to $10,000 for her student loans. Lucas: Right. Let's say your daughter graduates with $30,000 in federal student loans. You can take $10,000 out of the 529, tax-free, and apply it directly to her loan balance. That's $10,000 that never gets taxed or penalized. Luna: And the other $15,000? You could either leave it in the account for future use — say, if your daughter goes to grad school — or you could change the beneficiary to a sibling or a future grandchild. Lucas: Exactly. The key is that the scholarship doesn't trigger a penalty on withdrawals — there's a scholarship exception. Under the tax code, if the beneficiary receives a tax-free scholarship, you can withdraw up to the scholarship amount without the 10 percent penalty, though you still pay income tax on the earnings. Luna: So in this scenario, you could take out the $25,000 penalty-free because $15,000 of it is covered by the scholarship exception, and $10,000 by the student loan repayment provision? The earnings portion would be taxed as income, but no penalty. Lucas: That's the ideal outcome. But you have to be careful with the ordering. The scholarship withdrawal and the student loan withdrawal are separate provisions. And you need to keep good records of the scholarship amount and the loan disbursement. Luna: What about state tax deductions? In New York, you get a state income tax deduction for 529 contributions, up to $5,000 per year for an individual. If you withdraw that money for student loan repayment, does the state recapture the deduction? Lucas: That depends on the state. New York, for example, does not recapture the deduction as long as the withdrawal is for a qualified expense — and student loan repayment is a qualified expense under federal law. But not all states conform to the federal rule. Some states, like California and Oregon, do not treat student loan repayment as a qualified expense for state tax purposes. So you could still owe state income tax on the earnings, and possibly a state penalty. Luna: That's a critical nuance. You always have to check your own state's rules. The federal rules are generous, but state treatment varies widely. Lucas: Exactly. And there's one more thing to consider: the SECURE 2.0 Act, passed in 2022, added another option starting in 2024. You can now roll over up to $35,000 from a 529 plan into a Roth IRA for the beneficiary, subject to certain conditions. Luna: Right — that's a huge game changer for overfunded 529s. So now you have a potential choice: use $10,000 for loan repayment now, or roll over up to $35,000 into a Roth IRA that grows tax-free for retirement. Lucas: And you can actually do both. The loan repayment is a distribution, the Roth rollover is a transfer. They don't conflict. But the Roth rollover has a few hurdles: the 529 must have been open for at least 15 years, and the rollover is subject to the beneficiary's annual Roth IRA contribution limits — so it has to happen over multiple years. Luna: So for a family with a 529 that's been around for 18 years, they could use $10,000 for loans and then roll the rest into a Roth IRA over time. That's a powerful combination. Lucas: It is. And it makes the 529 plan even more flexible. But the loan repayment option is still worth knowing about, especially if the beneficiary has a lot of student debt and the Roth rollover would take too long to clear the balance. Luna: One thing I want to clarify: the $10,000 student loan limit — does that apply per borrower or per 529 account? Say a grandparent also has a 529 for the same kid. Lucas: It's per beneficiary. So if two separate 529 accounts name the same beneficiary, the combined distributions for student loan repayment cannot exceed $10,000. If you go over, the excess is a non-qualified withdrawal. Luna: Good to know. And what about loan types? Does it have to be a federal student loan, or can it be a private loan? Lucas: It can be either. The tax code defines qualified education loans broadly, covering both federal and private loans, as well as loans from a sibling or parent in some cases. But the loan must have been used for qualified higher education expenses for the beneficiary. Luna: So if a parent took out a Parent PLUS loan for their child, could the child's 529 be used to repay that loan? Lucas: No — because the loan is in the parent's name, not the beneficiary's. The distribution must go toward a loan for which the beneficiary is the primary obligor. Parent PLUS loans are the parent's debt, so they don't qualify. But if the child took out a loan in their own name, even with a parent as cosigner, it works. Luna: That's a common gotcha. So make sure the loan is actually in the student's name. Lucas: Absolutely. And the distribution should be made payable to the student, not directly to the loan servicer. You want a paper trail showing the money went to the beneficiary, who then used it to pay the loan. Luna: This episode has been really helpful — I feel like I understand the student loan repayment option much better now. And I think a lot of listeners with overfunded 529s will find it useful too. Lucas: If today was actually useful to you, the way these stay ad-free is listener support. You can buy me a coffee at buy me a coffee dot com slash fexingo. It helps us keep producing episodes like this without any ads. Luna: Yeah, it's a small way to keep the podcast independent. And we really appreciate it. Lucas: So back to the strategy — the bottom line is that student loan repayment is a valid, tax-smart use of leftover 529 funds, but you need to watch the $10,000 cap, state tax treatment, and the loan ownership. If you plan it right, you can turn excess savings into debt relief without triggering penalties. Luna: And if you're sitting on a 529 that's older than 15 years, don't forget the Roth IRA rollover as an alternative or complement. It's not an either-or. Lucas: Right. Between the scholarship exception, the student loan provision, and the Roth rollover, the overfunding problem has a lot more solutions than it did five years ago. The key is knowing which lever to pull, and in what order.