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529 Plans Just Became More Attractive for This Reason

By Maurie Backman - Updated Jan 18, 2020 at 11:15PM

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Hint: It's something a large number of former students are sure to celebrate.

The student debt crisis has gotten truly out of hand. Americans now owe a collective $1.59 trillion in outstanding loans, spread out across nearly 45 million borrowers. Not only can carrying that debt constitute a major financial burden, but it can also impede other important goals, like buying a home or saving for retirement.

But thanks to the newly implemented SECURE Act, borrowers have a new source of funding available to help pay down their student loans: 529 plans. These state-sponsored college savings plans were traditionally reserved for up-front education costs, like tuition, not the debt associated with getting a degree. But now, those who owe money in student loans can use up to $10,000 in tax-free 529 funds to pay down their debt. Not only could this serve as a lifeline to borrowers, but it also makes 529 plans a much more appealing savings option.

Cover of 529 savings plan with pen resting on it

Image source: Getty Images.

How 529 plans work

The money you put into a 529 is not tax-free, but once that account is funded, your invested savings are entitled to tax-free growth. Furthermore, withdrawals from a 529 plan are also tax-free provided they're used to cover qualified education expenses. For the record, that doesn't just mean college; you can use a 529 to pay for private school for a K-12 student as well.

In addition to tax-free investment growth and withdrawals, more than 30 states offer their own incentives for funding a 529. Usually, you'll need to contribute to your home state's plan to reap added tax benefits, though seven states -- Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania -- offer a state income tax break when you contribute to any state's plan.

But if there's one reason some families avoid these plans, it's that they're somewhat restrictive. If you wind up with an excess of funds in your 529 that you don't need for educational expenses, you'll face a 10% penalty if you remove that money for non-qualified purposes. And while that penalty applies only to the gains portion of your account, and not its principal, it's a deterrent for savers who would rather not have to worry about having more money in a 529 than they actually need. In addition, in that scenario, the earnings portion of your non-qualified withdrawal will be subject to taxes. And if you received a state-level tax benefit for funding your 529, you may need to pay some of it back if you use your funds for non-qualified purposes.

The new rules, however, offer even more flexibility for those who save in a 529, because now, up to $10,000 can be used to pay down existing student debt. Furthermore, that $10,000 applies on a per-borrower basis, so if you have a 529 plan with an extra $30,000 in it, and you and your two siblings each have student loans, you can each take a $10,000 withdrawal from that account to pay down your debt.

If you're in the process of saving for college, it pays to put money into a 529 plan. Not only will you enjoy some tax benefits, but you'll also have even more ways to use up that money if you end up in the fortunate position of having excess funds.

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