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Taking out loans even when you have the money
by Joe Hurley, founder, Savingforcollege.com
Monday, January 22nd 2007

[Updated March 27, 2008]

In September 2007, President Bush signed legislation that reduces the interest rate on subsidized student loans (Stafford) according to the following schedule:

Date of loan disbursement:	Fixed interest rate:
7/1/06 - 6/30/08	6.8%
7/1/08 - 6/30/09	6.0%
7/1/09 - 6/30/10	5.6%
7/1/10 - 6/30/11	4.5%
7/1/11 - 6/30/12	3.4%

(After June 30, 2012, the interest rate reverts to the 6.80% fixed rate.)

The rate reduction raises the following issue: If conditions are favorable for borrowers, should you or your child consider taking out an education loan even when you have funds in a 529 account?

Many people wrongly assume that you must use your 529 dollars to directly pay college expenses, and if you decide to take an education loan you would have to keep your money inside the 529 plan to avoid tax and penalty. In reality, 529 withdrawals can still be tax-free even when the college bills are paid from other resources, such as education loans. The law requires only that the 529 funds be withdrawn in the same year your beneficiary incurs qualifying college costs.

Example: Mary establishes a 529 account for her child Desmond. Desmond enters college in September 2011 and qualifies for a subsidized Stafford loan, which is interest-free during college and repayable at a 3.4% interest rate after college. Desmond takes out the maximum Stafford loan, and Mary requests an equivalent distribution from her 529 account made payable to Desmond. Desmond invests the 529 proceeds in a bank CD or some other investment vehicle. The 529 distribution is still tax-free even when it was not directly used to pay college bills.

Note: The anti-double-dipping rules can come into play to reduce an above-the-line deduction for education loan interest. The amount of the eligible loan is reduced by tax-free 529 distributions. The maximum interest deduction is currently $2,500 per year and is subject to income limitations and other requirements.

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