On December 20, 2019, President Trump signed into law a government spending bill which included many provisions of the SECURE Act (short for Setting Every Community Up for Retirement Enhancement Act—quite a mouthful). As its extended name would imply, most of the provisions of the SECURE Act affect retirement accounts like IRAs and 401ks. One particular aspect of the new law that we thought may be of particular interest to Insider blog readers (all diligent college savers, I’m sure!) affects the use of 529 Plans.
529 Plans are a tax-advantaged education savings account. Investments grow and can be withdrawn tax-free if used for qualified education expenses, including college tuition and mandatory fees, room and board, required books and supplies, computer and periphery, special needs expenses, and, beginning with the Tax Cuts and Jobs Act of 2017, up to $10,000 of K-12 tuition expenses annually.
The SECURE Act provisions signed into law expand the definition of qualified education expenses to include (1) fees, books, supplies, and equipment required for participation in a registered apprenticeship program and (2) the repayment of qualified education loans. It is this student loan provision that I find most interesting and want to dig into a bit further.
- The amount of student loan repayment considered a qualified education expense for 529 purposes is capped at $10,000 total per individual. It is not an annual limit like the K-12 tuition provision, but a lifetime cap.
- Education loans can be repaid for the account beneficiary and/or any of their siblings (again, up to $10,000 per sibling).
The expansion of 529 benefits to student loan repayment offers new flexibility to college savers, though, realistically, most families don’t have nearly enough money saved to cover initial college costs, let alone enough to have leftover funds to spend on post-graduate loan repayment. Still, I can envision a few scenarios in which the added 529 flexibility provided by the SECURE Act could help families.
- The benefit of an account with tax-free growth, like a 529, is maximized longer the money is allowed to grow in the account. The ability to use a 529 for a post-graduate expense, like student loan repayment, may allow growth-focused families to leave some funding in their account longer, maximizing their tax benefit. They may also be able to continue contributing to their 529 to qualify for an annual state tax deduction if their state offers one (*see state tax warning below). Note, however, that if you’re borrowing student loans instead of paying your college expenses up front, the return on your 529 investment must exceed the interest you’re being charged on your student loan for this strategy to make sense. The tactic may most benefit families who have some subsidized loan eligibility. Subsidized loans are interest-free while the student is in school, so a student could borrow $10,000 worth of subsidized loans, pay them off with 529 funds immediately upon graduation, and any gains on the 529 during the four years of college would be icing on the cake. (Understand, however, that 529s can also lose money—growth is not guaranteed—so this is not a risk-free proposition.)
- Families who have saved for college for multiple children, but not enough to fully pay for college, may benefit from the flexibility of being able to use 529 funds to repay the loans of siblings. Imagine a family with three kids with $20,000 in each child’s 529. The first two kids get through college, using a combination of 529 funding, student loans, and other resources. When it comes time for the third child to enroll in college, they decide not to attend—or they get a full scholarship—so the family does not have the college expenses for Child 3 to justify the spending down of their $20,000 529. Instead of taking an unqualified withdrawal subject to taxation (and maybe a 10% penalty) the family has the option of using Child 3’s 529 to help pay down the student loans of Children 1 and 2.
- While most 529s are held for students by their custodial parent(s), noncustodial parents or grandparents will sometimes save for their child/grandchild in a 529. As we’ve discussed previously on this blog, payments made for a student’s first year and a half of college from someone other than a custodial parent must be reported as student income on a financial aid application, and if total student income (including these 529 payments) exceeds an allowance of approximately $7,000, financial aid eligibility can drop substantially. To minimize this financial aid impact, a family may choose to hold back some 529 payments for the first year and a half, have the student borrow some student loans instead, and repay these loans out of the 529 later, when the payments will no longer affect financial aid. If the loans charge interest while enrolled, this is not a cost-free proposition, but this interest cost will need to be weighed against possible financial aid gains.
Before utilizing your 529 to repay education loans, note these two limitations to the new rule:
- The IRS does not allow “double-dipping,” or getting two tax breaks for the same payment. Student loan payments made out a 529 are not eligible payments for the purposes of claiming the Student Loan Interest Deduction.
- Not all states conform to the federal definition of “qualified education expenses” for their own state tax purposes, so while education loans are now a federally qualified 529 expense, loan repayment may not be a qualified expense in your state. Therefore, the earnings portion of 529 withdrawals made to repay student loans may be subject to state income tax, and possibly the recapture of a state tax deduction already received. Be sure check your state tax regulations before utilizing a 529 to repay education loans.