No tax perk if 529 money pays student loan

Question

Dear Joe, Can funds from a 529 plan be used to pay off student loans upon graduation? -- Scott

Answer

Dear Scott,

Withdrawals from a 529 plan are tax-free to the extent the account beneficiary incurs "qualified higher education expenses," or QHEE. The list of eligible expenses includes tuition, mandatory fees, books, supplies, equipment and the expenses of special needs beneficiaries. It also includes a capped amount of room and board if the beneficiary is at least a half-time student. However, QHEE does not include student loan repayments.

Some may argue that student loans merely represent the expenses incurred by the student in past years and should be counted as QHEE when the loans are repaid. The IRS apparently does not buy this argument and will count a student loan only for the year when the loan is taken out to pay the eligible expenses, not for the year the loan is repaid.

Here's an example.

John graduates from college in May 2007. In January 2007, John paid $10,000 for his final semester's tuition, fees, books, supplies, and room and board. To make these payments, he borrowed a total of $8,000 in federal and nonfederal student loans and paid the rest with earnings from a part-time job. John graduates from college with a total of $30,000 in loans. In July 2007, John's parents withdraw $30,000 from their 529 accounts (John is the beneficiary) so John can pay off all of his loans and begin his post-college life without debt.

John's qualified expenses for 2007 total $10,000 (the amount paid with cash and loan proceeds). Of the $30,000 in withdrawals from John's parents' 529 plan, $10,000 is a tax-free "qualified" withdrawal and $20,000 is a "nonqualified" withdrawal. The earnings portion, but not the principal portion, of the $20,000 nonqualified withdrawal is subject to income tax and a 10 percent federal tax penalty. The penalty is waived to the extent John received any tax-free scholarships in 2007.