529 plans are a tax-advantaged way to save for higher education, but the penalty for making non-qualified withdrawals can be a huge headache for those who don't use all the money they've accumulated on schooling. Fortunately, recent law changes have opened up new ways to use these accounts, including paying off some student loans. Here's what you need to know if you're considering this option.
There's a $10,000 lifetime maximum per beneficiary on repaying student loans with 529s
Under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, 529 account holders can use up to $10,000 in 529 funds per beneficiary for the repayment of qualifying student loans. Families with multiple children can withdraw more than this.
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For example, a plan holder with two children can withdraw up to $10,000 for each child's student loans, for a total of $20,000. But keep in mind that this is a lifetime maximum that applies to withdrawals from all 529 plans. There's no way to circumvent this limit by withdrawing $10,000 from one 529 plan and another $10,000 from another 529 plan for the same beneficiary.
Not all student loans qualify for 529 plan repayments
It's possible to use 529 funds to pay off federal and private student loans as well as parent student loans as long as they meet the following criteria:
- You or the account's beneficiary took out the loan solely for higher education expenses.
- The loan wasn't from a retirement plan or a relative.
- The loan must've been disbursed within 90 days of the date the education costs were paid.
- The student was enrolled at least half-time during the academic term the loan was for.
If you have any questions about whether you're able to use 529 plan funds to pay off your student loan, reach out to your lender for more information.
Using 529 funds for student loans affects your ability to claim the student loan interest deduction
Using 529 plan funds to pay off student debt could render you ineligible for the student loan interest deduction that year. Essentially, the IRS reduces the size of the student loan interest deduction you can claim by the amount of earnings that came from the 529 plan.
For example, the maximum student loan interest deduction in 2023 is $2,500. But if you make a 529 plan withdrawal to pay off your loans and $2,500 or more of that withdrawal came from investment earnings, you wouldn't be able to claim the student loan interest deduction that year. But if only $1,500 of your 529 withdrawal was earnings, you could still potentially claim up to a $1,000 student loan interest deduction, assuming you actually paid that much interest on a qualifying student loan during the year.
It's not possible to withdraw just your 529 contributions in order to avoid becoming ineligible for the student loan interest deduction. If 25% of your total 529 balance comes from earnings, 25% of every withdrawal is automatically considered to be from earnings as well.
Some states have different rules
The above terms apply to federal taxes, but states are free to make their own terms if they want. If your state refuses to acknowledge student loan payments as qualified education expenses, you could face state income taxes on these withdrawals.
Before you take any money out to pay for student loans, it doesn't hurt to check how your state handles this. You can reach out to your state department of taxation, your 529 plan administrator, or a tax professional who's versed in your state's tax laws to learn if this will be an issue for you.
If you don't think that a 529 withdrawal for student loan repayment is your best option, there are other ways you can use that cash. You're always free to make a non-educational withdrawal, though you'll face a 10% penalty on these. You could also change the beneficiary on the account to someone else in your family. Or you could do a 529-to-Roth IRA transfer beginning in 2024. Explore all your options before deciding which is best for you.
