Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plans Can Now Cover Student Loan Refinancing
Transcript
- Lucas: Luna, I want to talk about something that I think a lot of listeners have been hoping for: using a 529 plan to refinance student loans. It's actually been allowed since the Secure 2.0 Act passed back in late 2022, but I'm still surprised how few people know about it. Luna: Yeah, I've seen that number — the tax-free limit is $10,000 per beneficiary, right? But is that lifetime or annual? Lucas: Lifetime. It's a lifetime limit of $10,000 per individual. And here's the kicker: you can also use up to $10,000 for each of the beneficiary's siblings. So if you have a 529 plan set up for one child who doesn't need it all, you can redirect those funds to pay down loans for a brother or sister. Luna: Wait, so the sibling doesn't have to be the named beneficiary? The account owner just designates the distribution for the sibling's loan? Lucas: Exactly. The beneficiary stays the same, but the distribution can be used for a sibling of the beneficiary. The IRS defines sibling as brother, sister, stepbrother, or stepsister. So it's pretty broad. And the distribution comes out tax-free as long as it's used to pay qualified student loans. Luna: That's huge for families with multiple kids. But what about the timing — can you do this while the beneficiary is still in school, or does it have to be after graduation? Lucas: You can do it anytime the loan is outstanding. The loan has to be for the beneficiary or the sibling's own education — not for a parent's loan, unfortunately. And the distribution must be made directly to the loan servicer, or at least you need to keep documentation that you used it for loan repayment. The IRS wants to see that paper trail. Luna: Right, so no pulling cash out and then just writing a check to your kid. That would be a non-qualified distribution and you'd owe taxes plus the 10% penalty on earnings. Lucas: Exactly. And speaking of taxes, there's a nuance with state tax deductions. If you claimed a state tax deduction for contributions to that 529 plan, and then you use the money for loan refinancing instead of qualified higher education expenses, some states may recapture that deduction. So you could owe back some state income tax. Luna: Oof, that's an important trap. Which states are the strictest about that? Lucas: It varies. States like New York, Connecticut, and Indiana have clarified that loan repayments are treated as qualified expenses for state purposes too, so no recapture. But others, like Michigan and Minnesota, have said they will recapture the deduction if the distribution isn't for tuition, fees, or similar costs. You really have to check your own state's rules. Luna: So the federal treatment is clear, but the state treatment is a patchwork. That's a classic 529 complication. Lucas: Exactly. But let's say you're in a state that's friendly — what's the strategy? The $10,000 lifetime limit per borrower isn't huge, but it's meaningful. If you have a 529 account that's grown nicely and your kid doesn't need it all, shifting some to pay down loans can be smart. Luna: And if you have multiple kids, you could potentially move a lot of money. Say you have three kids, and you use $10,000 for each of them from one sibling's 529 — that's $30,000 total, tax-free. Lucas: Right. But the account owner needs to change the beneficiary to each sibling? Actually no — you don't change the beneficiary. The distribution is simply designated for the sibling's loan. The account stays in the original beneficiary's name. The sibling is just the recipient of the loan payment. Luna: That's cleaner than I thought. So you keep one 529 per child and just distribute from whichever account has extra funds. Lucas: Exactly. And there's another angle: you can also use the 529 to pay your own student loans if you're the beneficiary of the account. So if you set up a 529 for yourself years ago and never used it, you can now tap it for your own debt. Luna: Do these distributions count as income for the borrower? I'm thinking about things like income-driven repayment plans — if the loan is paid via 529, does that trigger a taxable event for the student? Lucas: No, it's not considered income to the borrower. The distribution is treated as a qualified education expense, so it's tax-free to both the account owner and the borrower. But it does count as a payment toward the loan, so it reduces the principal. It doesn't trigger any forgiveness or cancellation of debt income. Luna: Got it. So it's just like any other payment. One thing I'm wondering about: the $10,000 limit — is that per loan or per borrower? Lucas: Per borrower. So if your daughter has both federal and private loans, the $10,000 lifetime limit applies to all her loans combined. You can't do $10,000 for her federal loans and another $10,000 for her private loans. Luna: That makes sense. So the planning really comes down to: which loans have the highest interest rate? You'd want to target those first with the 529 money, because you're getting a tax-free return equal to that interest rate. Lucas: Exactly. And if your kid has multiple loans, you might prioritize the one with the highest rate — say a private loan at 7% versus a federal loan at 4.5%. The 529 distribution is essentially giving you a guaranteed 7% return by avoiding that interest. Luna: And if the 529 has grown a lot, you're also avoiding capital gains tax on the earnings. So the benefit is twofold: no tax on the growth, and you pay down high-interest debt. Lucas: Right. But there's a trade-off: once you take money out of a 529, it's gone. You can't put it back if your kid later decides to go to grad school. So you have to weigh the loan interest savings against the potential future need for education funds. Luna: That's a good point. If your kid is likely to pursue a master's or professional degree, you might want to keep the 529 funds for that, because tuition costs are only going up. Lucas: Speaking of costs — and this ties in — if you find these conversations helpful in making those trade-offs, it's worth mentioning that listener support is what keeps this show going. We don't run ads, and a small way to help is at buy me a coffee dot com slash fexingo. No pressure, just if you've gotten value. Luna: Yeah, even a one-time contribution helps us keep the episodes coming. And now back to the numbers: what about the interaction with the student loan interest deduction? If you use 529 money to pay interest, can you still deduct that interest on your taxes? Lucas: No, you cannot. The student loan interest deduction is only available for interest you actually pay. If the 529 pays it, you didn't pay it, so you can't deduct it. But that's a relatively small deduction — up to $2,500 per year — and it phases out at higher incomes. For many people, the benefit of using 529 money outweighs losing that deduction. Luna: And of course, the 529 money itself is tax-free, so you're comparing a deduction that reduces taxable income versus a distribution that's entirely tax-free. The tax-free distribution is usually better. Lucas: Exactly. Let's talk about one more nuance: the Secure 2.0 Act also allowed rollovers from 529 plans to Roth IRAs, up to $35,000 over a lifetime, starting in 2024. That's a separate provision, but it gives you another option if the beneficiary doesn't need the money for education or loans. Luna: Right, so you have a hierarchy: first use for qualified education expenses, then for student loan refinancing up to $10,000, then possibly a Roth rollover if the account has been open for 15 years. That's a lot of flexibility. Lucas: It really is. And the loan refinancing option is especially valuable for people who are just out of school and have a mountain of debt. Even $10,000 can make a real dent, and if you have siblings, you can help them too. Luna: But what about the account owner's own loans? If a parent set up a 529 for themselves and then later took out student loans for continuing education, can they use that 529 to pay their own loans? Lucas: Yes, as long as they are the beneficiary of the 529 account. If the account is in their name and they have outstanding qualified student loans, they can take a distribution up to $10,000 to pay those loans. Same rules apply. Luna: So really, anyone who is a beneficiary of a 529 and has student loans can benefit. That's a broad net. Lucas: Exactly. And the key takeaway is: don't leave 529 money sitting unused if someone in the family is carrying student debt. It's a tax-efficient way to help. Just be careful about state tax recapture, document everything, and think about whether you might need those funds for future education costs. Luna: And if you're unsure, talk to a tax professional or financial advisor. The rules are still relatively new, so professional guidance can save you from mistakes. Lucas: Great advice. Next episode, we'll look at how 529 plans can cover your child's certification and license exam fees — another lesser-known qualified expense. Luna: Looking forward to it.