Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / Using 529 Funds for Student Loan Repayment
Transcript
- Lucas: So we have talked a lot on this show about all the creative ways you can use a 529 plan — private school, trade school, even robotics competitions. But there is one use case that has become a lot more relevant since the SECURE Act passed in 2019, and we haven't really dug into it yet. Luna: Student loan repayment. I have a feeling a lot of families have wondered about this but aren't sure of the rules. Lucas: Exactly. The SECURE Act added student loan repayment to the list of qualified education expenses for 529 plans. That means you can take tax-free withdrawals from a 529 plan to pay down a beneficiary's student loans. But — and there is a big but — there is a lifetime limit. Luna: What is the cap? I've heard $10,000, but is that per beneficiary or per account? Lucas: It is $10,000 per beneficiary over their lifetime. And that is a federal limit, so it applies regardless of how many 529 accounts might be set up for that person. If grandma has a 529 for her grandchild and you have one for your child — same beneficiary — combined total can only use $10,000 for loan repayment. Luna: That makes sense. But $10,000 — for the average graduate with, what, around $30,000 in debt — that covers a meaningful chunk but not everything. Lucas: Right. And there is also a per-sibling wrinkle. If you have multiple kids, each one gets their own $10,000 limit. So if you have three children, that's $30,000 total that can come out of the 529 tax-free for loan repayment across all of them. Luna: So theoretically you could overfund a 529 for one child and then change the beneficiary to another sibling later to use the loan repayment benefit? Lucas: You can, but careful — each beneficiary still has their own $10,000 cap. So if you change the beneficiary from Child A to Child B, Child B gets their own $10,000 limit. But any amount used for Child A's loans counts against Child A's limit, not Child B's. So you can't stack multiple beneficiaries' limits onto one person's loans. Luna: Got it. Now, what about the student loan interest deduction? If you use 529 funds to pay the loans, can you still deduct the interest on your taxes? Lucas: This is a key gotcha. The IRS has clarified that you cannot double-dip. If the loan repayment is made with tax-free 529 funds, you cannot also claim the student loan interest deduction for that same payment. The deduction — up to $2,500 per year — is only available for interest you actually paid with after-tax dollars. Luna: So if you're in a higher tax bracket, the deduction might be worth more to you than the tax-free growth on the 529 withdrawal. It's a math problem. Lucas: Exactly. You have to compare: how much did the 529 earnings grow tax-free? Versus how much would you save by deducting the interest? For many families, the deduction is small — maybe $500 to $600 in actual tax savings — so the 529 route often wins. But it is not automatic. Luna: I want to talk about state tax treatment, because that could be the real trap. I've read that some states claw back the state income tax deduction you got on your 529 contributions if you use the money for loan repayment. Lucas: That is a huge point. Federal law says loan repayment is a qualified expense. But state law varies. Some states — like Arizona, Kansas, and Minnesota — have explicitly said they do not recognize loan repayment as a qualified expense for state tax purposes. So if you live in one of those states and you took a state tax deduction on your 529 contributions, you may have to add that deduction back as income when you use the funds for loan repayment. Luna: That basically negates the benefit of having used the 529 in the first place from a state tax perspective. Lucas: It can. So you really need to check your own state's rules. About 30 states conform to the federal definition, but even among them, some have quirks. For example, New York only allows the loan repayment if the 529 account has been open for at least two years. Otherwise they treat the withdrawal as non-qualified. Luna: Oof. So anyone planning to use 529 funds for loan repayment should look up their state's specific treatment before pulling the trigger. Lucas: Absolutely. And this brings up a bigger strategic question: should you even use a 529 for loan repayment? Or would you be better off using the 529 to pay tuition directly to reduce borrowing in the first place? Luna: That feels like the core planning decision. Let's say you have $20,000 in a 529. Option A: use it all for tuition freshman year, borrow less. Option B: pay minimal tuition from the 529, let loans accumulate, then use the 529 later for repayment. Which is better? Lucas: Let's run a simplified example. Say you have $20,000 in a 529, earning 6% annually. Tuition is $20,000 per year. Under Option A, you use the $20,000 for year one tuition. No loans needed that year. Under Option B, you take out a $20,000 loan at 5% interest, let the 529 grow for four years, then use the 529 to repay the loan. Luna: So we're comparing the 529's growth rate against the loan's interest rate. In Option A, the 529 doesn't grow because you spent it. In Option B, it grows at 6% while the loan costs 5%, so you come out ahead by 1% per year compounded. Lucas: Right. After four years, the 529 would be worth about $25,250, while the loan balance at 5% would be about $24,300. So you have roughly $950 extra. But — and this is important — that math only works if the 529's investment return exceeds the loan rate. With federal loan rates currently around 5 to 7 percent, and market returns historically around 7 to 10 percent, it can make sense. But it's not guaranteed. Luna: And there is the risk factor. The 529 is invested in the market, which can go down. The loan is a fixed obligation. So the comparison is not apples to apples on risk. Lucas: Exactly. If the market drops in those four years, Option B could leave you worse off. That's why many planners lean toward using the 529 for tuition directly, especially if the loan interest rate is high. But if you have a low rate — say 3 or 4 percent — letting the 529 grow might be worth the gamble. Luna: I also want to mention that the $10,000 lifetime limit per beneficiary can be a constraint. If you plan to use the 529 for loan repayment, you can only do $10,000. So if you're in Option B and you have a $30,000 loan, you can only cover $10,000 with the 529. The rest has to come from other sources. Lucas: That is a very practical limitation. So maybe the optimal strategy is a hybrid: use the 529 to pay some tuition directly, and also reserve some for future loan repayment if you have multiple beneficiaries. For example, if you have two kids, you could use $10,000 per child for loans later, and spend the rest on tuition now. Luna: I think a lot of listeners will be surprised to learn that loan repayment is even an option. The commonly cited rule is that 529 funds must be used for qualified education expenses, and most people think of tuition, room and board, and books. Lucas: Exactly. And the SECURE Act opened this door. But it also added apprenticeship programs as a qualified expense, and allowed 529 funds to be used for homeschooling expenses. So the flexibility has increased significantly. Luna: Speaking of flexibility, what about using 529 funds to pay someone else's student loans? Can you help out a sibling or a friend? Lucas: You can, but only by changing the beneficiary of the 529 account to that person first. The withdrawal must be for the beneficiary's qualified expenses. So you cannot just write a check from your 529 to cover your friend's loan. You would have to designate them as a new beneficiary — and they have to be a family member under the IRS definition. Cousins, aunts, uncles, nieces, nephews — all qualify. But not friends. Luna: That is important. What about if the beneficiary themselves is the one making the loan payments? Does the 529 have to be owned by the parent? Lucas: No. The account owner can take the distribution and pay the loan servicer directly. Or they can reimburse the beneficiary if the beneficiary made the payment themselves. As long as it's for the beneficiary's loans, it's fine. Keep documentation, obviously. Luna: I want to circle back to the state tax issue because I think it's the biggest hidden pitfall. Can you name a few states that are particularly problematic? Lucas: Sure. Besides the ones I mentioned — Arizona, Kansas, Minnesota — states like Indiana, Montana, and Utah have also issued guidance that they do not follow the federal definition. In those states, using 529 funds for loan repayment is a non-qualified withdrawal, so earnings are subject to state income tax and potentially a penalty. And if you claimed a state deduction on contributions, you'll have to recapture that. Luna: Wow. So really, the first step before using a 529 for loan repayment is to Google your state's rules plus '529 student loan repayment'. Lucas: Absolutely. And if you live in a state that does conform, you still need to check for any additional requirements. For example, some states require that the 529 account has been open for a minimum number of years. Luna: So for our listeners who are thinking about this, what is the takeaway? Should they consider using their 529 for loan repayment, or is it better to plan ahead and avoid loans altogether? Lucas: I think it depends on their financial situation and risk tolerance. If you are confident you can save enough in the 529 to cover a significant portion of college costs, then paying tuition directly to minimize borrowing is probably the simpler, safer route. But if you end up with leftover 529 funds — maybe because your child got a scholarship — then loan repayment is a great way to use that money without incurring a penalty. Luna: That's a key point. The 10% penalty on non-qualified withdrawals can be steep. So having loan repayment as an option reduces the risk of overfunding a 529. Lucas: Exactly. And that flexibility is valuable. Before 2019, if your child got a full scholarship, your only options were to change the beneficiary or take a penalty. Now you can use up to $10,000 for loans. It is not a huge amount, but it helps. Luna: Alright, I think we have covered the main rules and strategies. One last thing: what about using 529 funds for parent PLUS loans? Can you use the 529 to pay off a parent's loan taken out for the child's education? Lucas: Yes, that is allowed under the SECURE Act. The parent PLUS loan is a student loan for the child's education. So if the parent is the beneficiary of a 529 account, they can take a distribution to pay their own PLUS loan. But again, the $10,000 lifetime limit applies per beneficiary. So if the parent is the beneficiary, they have $10,000 total for all their student loans, including PLUS loans. Luna: Got it. So it is very much a per-person limit. That makes sense. Lucas: Alright, I think we have given listeners a lot to think about. Let me just recap the key numbers: $10,000 lifetime limit per beneficiary, no double-dipping with the student loan interest deduction, and watch your state's rules. If you handle it correctly, 529 loan repayment can be a smart move. Luna: And if you are already making loan payments, keep in mind that you can still use a 529 for future payments as long as you are within the lifetime limit. It is not a one-time thing. Lucas: Great point. Well, that is a lot of practical guidance. And if you want to see how we think through these scenarios, or maybe you have a specific situation you want to run by us, you can always reach us through the show notes. Also, if these episodes have been helpful to you, we do rely on listener support to keep them ad-free. A couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you have gotten something out of them. Luna: Yeah, it really does make a difference. Even a small contribution helps cover the costs of research and production. Lucas: So thanks for considering that. Now, next episode we are going to tackle a question we have gotten a lot: can you use a 529 plan for a child's gap year program? That is going to be a fun one. Luna: Looking forward to it. See you next time.