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Utilizing a 529 Plan for Student Loans
Recent changes allow families to use 529 plans to repay student loans, though there are important limitations to keep in mind.
The SECURE Act of 2019 has expanded the definitions of qualified distributions, permitting withdrawals from 529 plans to pay down the principal and/or interest on the qualified education loans of the beneficiary or their siblings.
However, there are several rules and restrictions to consider before accessing your 529 plan for loan repayment.
Limitations on 529 Plan Withdrawals for Student Loans
- Lifetime Disbursement Limit: Distributions for student loan repayment are capped at $10,000 per borrower. This limit is cumulative across all 529 plans, meaning you cannot exceed this amount by drawing from multiple plans. For instance, if a beneficiary has a parent-owned and a grandparent-owned 529 plan and withdraws $10,000 from each, only the first $10,000 will qualify for student loan repayment.
- The cap applies equally if the borrower has two plans owned by the same parents. Thus, a maximum of $10,000 in combined distributions can be used to repay student loans, regardless of any other 529 plan holdings.
- Once a borrower utilizes the $10,000 limit for student loan repayment, further withdrawals for that purpose will not be recognized as qualified distributions, as this is a lifetime cap.
- This limit is applicable per individual borrower, meaning if the original borrower refinances their loans to another person (like a spouse), the new borrower can potentially receive another $10,000, provided they have not yet reached their own lifetime limit.
Repaying Parent Loans with 529 Plans
529 plan account holders can change the beneficiary to a parent, allowing the account to address up to $10,000 of parent education loans as well. If both parents have taken out loans for their educational pursuits, the account owner may switch beneficiaries to use the funds towards settling each parent’s education debts.
Despite this, all loans—whether for students or parents—are collectively limited to $10,000 in qualified distributions.
Not All Student Loans Qualify
To qualify for repayment via a 529 plan, a loan must satisfy specific criteria:
- It should have been used solely for qualified higher education expenses.
- Mixed-use loans, such as home equity loans, do not qualify.
- Loans that surpass cost of attendance due to other aid are ineligible.
- Loans must not originate from relatives to the borrower.
- The loan needs to be obtained within 90 days of paying college costs.
- The student must have been enrolled at least half-time during the term for which the loan was issued.
- The student must be enrolled in an eligible degree or certificate program.
- The institution attended must qualify for Title IV federal student aid.
State Variations on 529 Plan Usage
Some states do not align with federal definitions of qualified expenses for 529 plan distributions. Therefore, using these funds for student loans might be categorized as non-qualified at the state level, potentially incurring state income tax or the loss of previous tax breaks associated with non-qualified withdrawals.
Implications for the Student Loan Interest Deduction
The IRS prohibits double benefits. If student loans are paid off using funds from a 529 plan, the amount eligible for the Student Loan Interest Deduction may be diminished. This deduction allows for an exclusion of up to $2,500 in interest paid on qualified education loans.
For instance, if a third of the 529 distribution comes from earnings, and a borrower takes a $10,000 withdrawal, their eligibility may be affected accordingly. Conversely, extracting from the 529 plan with the least earnings proportion could preserve eligibility for the Student Loan Interest Deduction.
For the current status of state regulations and further details, refer to the 529 plan guide to ensure compliance with both federal and state criteria.