Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / Using a 529 Plan to Refinance Your Childs Student Loans
Transcript
- Lucas: So you've done everything right — saved in a 529 plan for years, maybe even decades. Your kid graduates college, starts their career, and suddenly you're looking at a leftover balance in that account. What now? Luna: It's a good problem to have, sure, but it's still a problem. Take the money out for non-qualified expenses and you're hit with taxes plus a 10 percent penalty on the earnings. Lucas: Right. But there's a lesser-known option that might help: using leftover 529 funds to pay down your child's student loans. The Tax Cuts and Jobs Act of 2017 opened this door — you can take distributions from a 529 plan to repay the beneficiary's student loans, up to a lifetime limit of $10,000 per beneficiary. Luna: Ten thousand dollars. That's not nothing — the average student loan balance for recent graduates is around thirty thousand, so this could cover about a third of that for some people. Lucas: Exactly. And it's important to note that the $10,000 limit is per beneficiary, not per account. So if a student has multiple 529 plans in their name, the total across all of them can't exceed that amount. Also, this applies to both federal and private student loans. Luna: What about PLUS loans — the ones parents take out for their kids? Can those be paid with 529 funds too? Lucas: Great question. Yes — the rule allows up to $10,000 in 529 distributions to repay a parent's PLUS loan, but it's treated separately. So theoretically, a family could use $10,000 for the child's loans and another $10,000 for a parent's PLUS loan. That's $20,000 total, though you'd need two separate loans to make that work. Luna: That's a nice little strategy. But I imagine the tax treatment here matters — is it truly tax-free like tuition payments? Lucas: Yes and no. The earnings portion of the distribution is tax-free as long as it's used for qualified education expenses, and student loan repayment is now considered a qualified expense. But here's the nuance: the $10,000 limit applies to the total distribution, not just the earnings. So if you take out $10,000 and $6,000 of that is contributions you already made with after-tax dollars, you're only getting tax-free treatment on the $4,000 in earnings. Luna: Right — same as any 529 distribution. Contributions come out tax-free because they were already taxed going in. It's the growth that gets the tax advantage. Lucas: Exactly. And remember — this is a lifetime limit per beneficiary. You can't use $5,000 one year and another $5,000 the next year. Once you hit $10,000 total across all years, that's it. So you want to be strategic about when you use it. Luna: Who's the beneficiary here? If the student is the one taking out the loans, they're the beneficiary, right? Lucas: Right — the loan must be in the name of the 529 plan's beneficiary. So if your child is the beneficiary and they have loans in their name, you can use the 529 to pay those loans. But if you're the parent with a PLUS loan in your name, you'd need to be the beneficiary of the 529 plan. That might mean changing the beneficiary on the account, which is usually straightforward — you can change it to yourself, a sibling, or even a cousin without penalty. Luna: Let's talk about the elephant in the room: student loan interest deduction. If someone pays off their loans with a 529 distribution, do they still get to deduct the interest on their taxes? Lucas: That's a great point, and the answer is no. The IRS says that any student loan interest paid with tax-free funds — including 529 distributions — is not deductible. So you lose that deduction on the portion paid by the 529. But honestly, the deduction is capped at $2,500 per year and is subject to income phaseouts, so for many families the tax-free 529 distribution is still a better deal. Luna: Makes sense. Let me ask this — what if the child hasn't graduated yet, but you know they'll have loans? Can you use the 529 to pay interest while they're still in school? Lucas: Yes, you can. The rules allow 529 distributions for student loan repayment at any time — even while the borrower is still enrolled. But remember the $10,000 lifetime limit. If you use $2,000 to pay interest during school, you only have $8,000 left for after graduation. So it's probably better to save that limit for when the loans enter full repayment. Luna: Now let's compare this to another option: the 529-to-Roth IRA rollover. That's been a hot topic since Secure 2.0 passed. How do these two strategies stack up? Lucas: Good comparison. Starting in 2024, you can roll over up to $35,000 from a 529 plan into a Roth IRA for the beneficiary, subject to annual Roth contribution limits. That's a much higher limit than the $10,000 for student loans. But there are catches: the 529 must have been open for at least 15 years, and the rollover can't exceed the beneficiary's earned income for the year. So if your kid is a recent grad with a job, the Roth rollover might be more valuable long-term. Luna: So which should someone prioritize? Paying off loans or putting money into a Roth? Lucas: It depends on the interest rate on the loans. If your child has federal loans at 4 or 5 percent, investing that money in a Roth where it can grow tax-free for decades could be a better move. But if they have private loans at 7 or 8 percent, paying those down with the 529 might be the smarter financial decision. There's no one-size-fits-all answer. Luna: And you could do a mix — use some 529 money for loans and some for the Roth rollover. The $10,000 loan limit and the $35,000 Roth limit are separate, right? Lucas: Correct — they're independent. So in theory, a beneficiary could benefit from both strategies: up to $10,000 in student loan repayment and up to $35,000 rolled into a Roth IRA. That's a total of $45,000 in tax-advantaged benefits from leftover 529 funds. Of course, you'd need a very large 529 balance to have that much left over. Luna: Let's walk through a real example. Say a family saved $80,000 in a 529 for their daughter. She goes to a state school, gets some scholarships, and only uses $60,000. There's $20,000 left. What should they do? Lucas: Perfect scenario. First, they could use $10,000 to pay down her student loans — assuming she has any. Then they could roll over the remaining $10,000 into a Roth IRA for her, but only if the 529 plan has been open for at least 15 years. If not, they might need to wait, or consider changing the beneficiary to another child or even themselves. Luna: What if they don't want to do either? Could they just leave the money in the 529 for future grandchildren? Lucas: Absolutely. You can change the beneficiary to a grandchild without penalty. That's one of the most flexible features of 529 plans — the beneficiary can be changed to a wide range of family members. So that $20,000 could sit and grow for another 20 years before a grandchild uses it for college. No taxes, no penalties. Luna: I want to touch on something practical: how does the student loan repayment work in terms of paperwork? Do you send the 529 distribution directly to the loan servicer, or can you take the money and pay the loan yourself? Lucas: The IRS doesn't mandate a specific method, but the safest approach is to have the 529 plan send the distribution directly to the loan servicer. That way you have a clear paper trail. If you take the money yourself and then pay the loan, you'll want to keep meticulous records — the date of the distribution, the date you paid the loan, and proof that the loan was for the beneficiary. Luna: State tax treatment is another wrinkle. Some states offer a state income tax deduction for 529 contributions, but do they also treat student loan repayments as qualified expenses for state purposes? Lucas: It varies by state. Most states follow the federal rules and treat student loan repayments as qualified expenses, but not all. For example, California and a few other states haven't conformed to the federal rule change. So if you live in a state that doesn't recognize student loan repayment as a qualified expense, you might owe state income tax on the earnings portion of the distribution. Always check your state's specific rules. Luna: Good reminder. Let's talk about timing — is there a deadline to use the 529 for student loans after graduation? Lucas: No federal deadline. You can use the 529 for student loan repayment at any time — even years after graduation. The $10,000 lifetime limit applies regardless of when the distribution is taken. So if your child graduates and doesn't have loans right away, or if they go to graduate school first, you can wait. Luna: One more angle: what about using a 529 to pay for loan consolidation or refinancing fees? Are those covered? Lucas: Probably not. The IRS specifically says the distribution must be used to repay a qualified education loan. Fees associated with refinancing or consolidation aren't loan principal or interest — they're service charges. So those wouldn't qualify. Stick to paying down the actual loan balance. Luna: You know, this episode reminds me of how powerful these accounts can be beyond just tuition. We've talked about using them for everything from study abroad to summer camps, and now student loans. Lucas: Speaking of that — if you're finding these conversations helpful, we just wanted to mention that the show stays ad-free thanks to listener support. A couple of dollars a month genuinely keeps it going — buy me a coffee dot com slash fexingo. It's a small way to help us keep bringing you practical, actionable episodes like this one. Luna: Yeah, it really does make a difference. Every bit helps us keep the lights on and the content free for everyone. Lucas: Okay, back to the topic. One thing I want to emphasize: don't overlook the possibility of using a 529 for student loans just because the limit seems small. Ten thousand dollars is a meaningful chunk of debt for most graduates. And when combined with other strategies like the Roth rollover or beneficiary changes, it can be a really smart way to repurpose savings. Luna: Let's talk about a specific scenario: what if the student doesn't have any loans? Maybe they graduated debt-free thanks to the 529. Then what's the best use of leftover funds? Lucas: If there are no loans, the student loan repayment option is off the table. Then you're looking at the Roth rollover — if the 529 has been open 15 years — or changing the beneficiary to another family member. Or you could simply leave the money in the account for future education expenses, like graduate school or even continuing education later in life. Luna: And remember, the definition of 'beneficiary' is broad — it includes siblings, first cousins, nieces, nephews, and even the account owner's spouse. So there's a lot of flexibility. Lucas: Exactly. Let's also talk about the risk of overfunding a 529 in general. Some parents worry about saving too much. But with options like student loan repayment, Roth rollovers, and beneficiary changes, the risk is much lower than it used to be. You have multiple escape hatches. Luna: Sure, but there is still a limit. If you massively overfund — say $200,000 for one child — you might not be able to use all of it even with these strategies. The Roth rollover is capped at $35,000, and student loan repayment at $10,000. So you'd still have a lot left. Lucas: That's true. In that case, you could change the beneficiary to multiple people over time — maybe a sibling, then a cousin, then a grandchild. Each beneficiary gets their own $10,000 loan repayment limit and their own Roth rollover eligibility. So the total amount you can move out tax-free can be quite large if you have multiple beneficiaries. Luna: But each beneficiary can only get $10,000 in loan repayments total, across all 529 accounts. So you can't game the system by opening multiple accounts for the same person. Lucas: Right — the limit is per beneficiary, not per account. The IRS is pretty clear on that. So plan accordingly. Luna: I think the takeaway here is: don't be afraid to save in a 529. The flexibility keeps expanding. And if you do have leftover funds, student loan repayment is a solid option — especially for families with high-interest debt. Lucas: Absolutely. It's another tool in the toolbox. And as always, the key is to think ahead. If you know your child will have loans, structure your 529 contributions and distributions to maximize the $10,000 limit. Maybe even coordinate with other family members who might have 529 accounts for the same beneficiary. Luna: Interesting — so if grandparents also have a 529 for the same grandchild, they could use their account to pay loans too, but the total still can't exceed $10,000 across all accounts for that child. Lucas: Exactly. So coordination is important. Otherwise you might accidentally exceed the limit and trigger taxes and penalties on the excess. Luna: Good point. Well, Lucas, I think we've covered the key angles here. Any final thoughts? Lucas: Just this: the student loan repayment option is still relatively new and underutilized. A lot of families don't know about it. So if you have a 529 and your child has loans, it's worth looking into. And as always, consult a tax professional to make sure you're handling it correctly for your specific situation. Luna: Wise advice. Thanks for listening, everyone — we'll catch you next time on The College Savings Podcast.