Can You Use a 529 Plan to Pay Off Student Loans?

A 529 plan, traditionally used for financing higher education expenses, has recently expanded its scope. These plans can now be used to pay off student loans, offering a valuable tool for families managing educational debt. This change, introduced under the SECURE Act in December 2019, is especially relevant given the growing concern over student loan burdens.

Criteria for Qualified Loan Repayment

The SECURE Act allows account holders to use up to $10,000 from a 529 plan to repay student loans. This is a lifetime limit per beneficiary, not an annual cap. Families with multiple children can allocate up to $10,000 per child for student loan repayment, offering flexibility in managing educational debt.

The funds can be used to repay loans taken out by the beneficiary or their siblings, but only the principal and interest on qualified education loans are covered. Fees or penalties associated with loans are not eligible. Understanding these restrictions is crucial to avoid tax issues or penalties.

Federal Tax Rules

Withdrawals from 529 plans used for qualified student loan repayments are not subject to federal income tax, provided they stay within the $10,000 lifetime cap per beneficiary. Exceeding this limit can result in a 10% penalty on earnings and federal income tax on the earnings portion, making precise calculations essential.

There is also an important interaction between 529 plans and the American Opportunity Tax Credit (AOTC). Expenses covered by tax-free 529 distributions cannot be used to claim the AOTC. Strategic planning is necessary to maximize educational tax benefits and avoid disqualifying from other credits.

State Level Differences

State-level laws regarding 529 plans vary, adding complexity. Some states offer tax deductions or credits for contributions, while others, like California, do not. For example, New York allows a state income tax deduction for contributions up to $5,000 per taxpayer.

However, not all states recognize student loan repayments as qualified expenses. Illinois, for instance, has not aligned its tax codes with federal rules, potentially leading to state tax liabilities even when federal guidelines are met. Additionally, some states may require taxpayers to repay state tax benefits if 529 funds are used for loan repayment, even if federally qualified. Understanding these nuances is key to optimizing 529 plan benefits.

Documentation and Recordkeeping

Keeping accurate records is essential when using 529 plans for student loan repayment. Retain documentation of all contributions and withdrawals, including receipts, bank statements, and related correspondence. This ensures a clear audit trail in case the IRS requires proof that distributions were used for qualified expenses.

Financial tools can help track contributions, withdrawals, and progress toward the $10,000 lifetime cap, minimizing the risk of overages that could trigger penalties. Maintaining organized, easily accessible records is critical for tax compliance and peace of mind.