Can I Use a 529 Plan to Pay My Student Loans?

“Can I use a 529 to pay student loans?”

Yes!

A 529 plan could be a great vehicle for education funding, and now it can be used strategically to pay off student loan debt thanks to the Setting Every Community Up for Retirement Enhancement (SECURE) Act.

How does a 529 plan work?

This payment option is possible with the federal tax code’s expansion of the term “qualified higher education expense.” It now includes a reference to amounts paid as principal or interest on any qualified education loan of the designated beneficiary or a sibling of the designated beneficiary.

However, nonqualified education expenses paid for with funds from a 529 account would incur a 10% penalty as well as federal (and maybe state) income taxes on the earnings portion of the withdrawal. So, this change in law is a win for folks who want to use 529 monies to pay off student loan balances without a penalty.

Note there is a lifetime limit of $10,000 that can be used from a 529 plan for student loan repayment without tax penalty in most states. But the $10,000 limit is applied on a per-recipient basis.

Using 529 money to pay student loans?

Step 1: Check your state's definition of qualified education expenses

Before you make a distribution from the 529 account, make sure your state has accepted the federally expanded definition of “qualified higher education expense” that includes student loans as a qualifying expense. Call your plan’s customer service center to inquire.

If your state does include student loan payments as a qualifying expense, you or the account owner will avoid paying the 10% penalty and federal (and state, if applicable) taxes on the earnings of that withdrawal.

Check state laws to know your potential tax consequences for both withdrawals and contributions. For example, if you move or are managing a 529 account in another state, review the state laws for where the account is maintained as well as where you reside and file taxes.

“Many states offer tax benefits for contributions to a 529 plan. These benefits may include deducting contributions from state income tax or matching grants but may have various restrictions or requirements. In addition, savers may only be eligible for these benefits if you invest in a 529 plan sponsored by your state of residence,” according to the Securities and Exchange Commission.

Additionally, some states offer multiple types of 529 plans and allow you to have multiple plans. “Always consider your home state plan as it may offer state tax or other benefits for residents,” according to the College Savings Plan Network. To help people understand the differences in plans, such as fees and other factors, the CPSN created this state 529 plan comparison tool. 

Step 2: Withdraw the amount you want to apply to your student loans

Withdrawals may be made in lump sums or systematically over time. You can request a withdrawal by mail, by phone or from the plan’s website.

You can pay the institution, send it directly to the beneficiary or reimburse yourself. But no matter which payment method you choose, be sure to keep all receipts to substantiate qualification.

And remember, the SECURE Act established a $10,000 lifetime limit per beneficiary on account funds used to pay down student loans.

Step 3: Apply the distribution to your student loans

Timing is important to consider regarding your 529 withdrawal tax implications. The withdrawals you take from your 529 account must match up with the payment of your student loans in the same tax year.

If you withdraw the 529 money in December but don’t make that student loan payment until January, you risk not having enough qualifying expenses during the year of the 529 withdrawal (such as if you’ve paid off your student loan balance with that 529 disbursement).

Likewise, if you take a distribution in January to pay for expenses from the previous December, that distribution will be a nonqualified distribution.

529 plans and taxes

Additionally, there is no double-dipping, so to speak, with the student loan interest deduction. No deduction shall be allowed for any amount for which a deduction is allowable under any other provision.

So, with the student loan interest deduction, you can’t deduct interest from a student loan paid by a distribution of earnings from a 529 to the extent the earnings are treated as a tax free because they were used to pay student loan interest.

Some states did not automatically conform to the federal definition of “qualified higher education expenses” that went into effect with the Tax Cuts and Jobs Act. Therefore, the SECURE Act’s expansion to include student loans may not apply for the state tax deduction.

If the state does not conform to the new federal tax laws, the earnings portion of a 529 plan distribution used to repay student loans is subject to state income taxes.

I highly recommend you look into your state’s specific laws regarding 529s before using those funds.

State-specific 529 plan rules you should know

Contributions

Thirty-four states (plus the District of Columbia) offer a 529 state income tax deduction and/or income tax credit for 529 plan contributions. But these tax incentives are usually only available to residents who use an in-state 529 plan. These states include:

• Alabama
• Arizona
• Arkansas
• Colorado
• Connecticut
• District of Columbia
• Georgia
• Idaho
• Illinois
• Indiana
• Iowa
• Kansas
• Louisiana
• Maryland
• Massachusetts
• Michigan
• Minnesota
• Mississippi
• Missouri
• Montana
• Nebraska
• New Mexico
• New York
• North Dakota
• Ohio
• Oklahoma
• Oregon
• Pennsylvania
• Rhode Island
• South Carolina
• Utah
• Vermont
• Virginia
• West Virginia
• Wisconsin

Seven states do not have a personal income tax. Therefore, they do not have a state deduction or credit opportunity on contributions:

• Alaska
• Florida
• Nevada
• South Dakota
• Tennessee
• Texas
• Washington

Four states have fully deductible contributions:

• Colorado
• New Mexico
• South Carolina
• West Virginia

Seven states allow you to claim a state tax deduction or credit for contributions to any 529 plan (you don’t have to be a resident):

• Arizona
• Arkansas
• Kansas
• Minnesota
• Missouri
• Montana
• Pennsylvania

Four states have a requirement to hold funds in a 529 plan account for a specified amount of time to be eligible for a state income tax benefit:

• Michigan
• Minnesota
• Montana
• Wisconsin

Eight states (and the District of Columbia) only allow the 529 plan account owner (or owner’s spouse) to claim any tax benefit:

• Iowa
• Massachusetts
• Montana
• Nebraska
• New York
• Rhode Island
• Utah
• Virginia
• Washington, DC

Distributions

Eight states do not offer a state income tax deduction or credit, but qualified 529 plan distributions are exempt from state income tax:

• California
• Delaware
• Hawaii
• Maine
• Kentucky
• New Hampshire
• New Jersey
• North Carolina

The states that don't have a personal income tax (listed above) also don't have a state income tax on 529 distributions.

Other benefits

529 plan investments grow on a tax-deferred basis, and distributions are tax-free when used to pay for qualified expenses. Qualified 529 plan distributions are also excluded from state taxable income.

How to take advantage of tax credits and deductions when contributing to a 529 plan?

Follow these steps to reap the full benefits of contributing to a 529 plan:

1. Make sure your 529 account offers tax deductions or credits in the first place.
2. Find out if your state gives the tax benefit to the taxpayer or the account owner.
3. Make contributions, and come tax time, report those contributions on your state tax return to claim any available tax credit or deduction. You will receive the IRS form 1099-Q to help you report these contributions. Here’s a calculator to help you estimate what deduction you could expect.

Although using 529 monies may only happen or be needed in limited circumstances, it’s good to know that things are continuing to get more favorable for student loan borrowers.

Disclaimer: This content is not considered tax or legal advice. Consult a qualified tax professional and your state’s 529 plan professionals to find out how the SECURE Act could work for you in your state.