Can you use a 529 plan to pay off student loans?

Mark KantrowitzBy Mark KantrowitzBy

Some students graduate with leftover money in their 529 college savings plan and would like to use this money to pay off all or part of their student loan debt. Unfortunately, student loans are not considered to be a qualified higher education expense for 529 plans under current law.

If a 529 plan distribution is used to pay off or make payments on student loans, it will be a non-qualified distribution. The earnings portion of the non-qualified distribution will be subject to income tax at the beneficiary’s rate, plus a 10% tax penalty. A non-qualified distribution may also be subject to recapture of any state income tax benefits attributable to the distribution.

Cost of a Non-qualified Distribution to Repay Student Loans

Suppose a borrower takes a $10,000 non-qualified distribution from their 529 plan to pay down their student loan debt. The non-qualified distribution will yield a tax liability. The amount of the tax liability will depend on how much of the distribution is earnings and on the borrower’s tax bracket.

Typically, earnings represent about 10% to 30% of the distribution amount, or $1,000 to $3,000 per $10,000. When parents start saving at birth, about a third of the account balance will come from earnings. When parents wait until the child enters high school to start saving, less than 10% of the account balance will come from earnings.

If the borrower is in the 12% tax bracket, the tax liability will be $220 to $660, depending on the percentage from earnings and including the 10% tax penalty. If the borrower is in the 24% tax bracket, the tax liability will be $440 to $1,320.

Thus, the cost of using a non-qualified 529 plan distribution to pay off student loans will probably be between $220 and $1,320 per $10,000.

Proposals to Allow 529 Plans to Repay Student Loans Tax-Free

There have been several legislative proposals to treat student loan payments as a qualified higher education expense for 529 college savings plans:

  • On July 24, 2018, Rep. Kevin Brady (R-TX-8), who is chairman of the House Ways and Means Committee, proposed allowing borrowers to use 529 plan funds to pay off student debt as part of Tax Reform 2.0. Subsequent legislation, which passed the House, would limit the use of 529 plan money to repay student loan debt to $10,000 per borrower. This legislation, the SECURE Act, is likely to pass Congress, due to overwhelming bipartisan support.
  • On January 13, 2017, Rep. Lynn Jenkins (R-KS-2) and Rep. Ron Kind (D-WI-3) introduced the 529 and ABLE Account Improvement Act of 2017, which would have allowed 529 plan distributions to make payments on qualified education loans without the 10% tax penalty on non-qualified distributions. The distributions would still be subject to ordinary income taxes on the earnings portion of the distribution.
  • On April 15, 2010, Rep. Melissa L. Bean (D-IL-8) introduced the College Savings Flexibility Act of 2010, which would have allowed payments of principal and interest on qualified education loans as a qualified 529 plan distribution from 2010 through 2014, inclusive. The goal was to allow families to delay taking distributions from their 529 plans after the large stock market losses of 2008 and early 2009. The legislation was never reported out of committee.

Note that if student loans are added as a qualified higher education expense for 529 plans, the interest portion of any payments made with 529 plan funds will not be eligible for the student loan interest deduction.