You Could Soon Use a Section 529 Plan To Pay Off Student Loans. Here’s Why That Might Be a Bad Idea.

You may soon be allowed to use Section 529 plans to pay up to $10,000 in student loan debt. Earlier this month, the House Ways and Means Committee unanimously passed a bill called the SECURE Act. That is, “Setting Every Community Up for Retirement Enhancement.” Among other things, this bill expands Section 529 plans to include the cost of apprenticeship programs, homeschooling, and up to $10,000 in student loan principal and interest payments.

Politicians will certainly congratulate themselves. But once you look at the mechanics of the bill, it’s tough to see who would actually be able to benefit from doing so.

If the bill passes, it would represent the second major expansion of Section 529 benefits in the last two years: Section 529s were expanded to cover K-12 private school tuition as part of the Tax Cuts and Jobs Act, which President Trump signed into law in the closing days of 2019.

Criticism

Critics of the bill indicate that the Section 529 provisions would disproportionately benefit the children of wealthier families: They are the ones who are most likely to own 529 plans in the first place, and the wealthier ones are the ones more likely to have money left over in the plan after college that they can direct towards student loan debt.

State Tax Planning

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Some are pointing out the possible benefits of making student loan payments out of a Section 529 plan, and thereby taking advantage of state tax deductions and paying off up to $10,000 in student loans with money not subject to state income tax.

Currently, 34 states, plus the District of Columbia, offer a tax deduction for contributions to Section 529s. If you’re in one of them, and you have student loan debt, you can contribute to your state’s Section 529 plan. Then take the distribution a few days later and make your student loan payment.

This strategy would not work in California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, North Carolina or Tennessee.* These states currently have state income taxes but do not offer a state income tax deduction or tax credit for contributions to the state’s 529 college savings plan.

Example

The State of Oregon imposes a top marginal state income tax bracket of 9.9%. That rate applies to all taxable income earned over $125,000 ($250,000 for married couples.

That sounds like a lot to, say, a freelance web content writer.

But a physician with loads of student loan debt can easily meet that income threshold shortly out of residency.

If you take $10,000 and put it into the Oregon Section 529 plan, wait a month, and then take the money out to pay down your student loans, you could save $990, which is the amount you would have paid on that money, in state taxes, if it weren’t for the Section 529.

BUT…

If you use this benefit, the amount you take out for this purpose will reduce the student loan interest deduction by the same amount.

So if you paid $2,500 in student loan interest that is normally deductible, but you take out more than $2,500 from a Section 529, then you can’t take the student loan deduction. That affects your federal return, and federal tax rates are much higher than state tax rates.

Here’s the relevant part of the bill:

It doesn’t make sense to give up a federal tax deduction in the 22 percent tax bracket to take a tax deduction in the 9.9% bracket!

Also, it’s not a $10,000 student loan payment benefit limit per year. Currently, the law would cap the benefit at a $10,000 lifetime limit for any given 529 plan beneficiary.

All told, it’s hard to see who would actually benefit from actually using this provision.

This doesn’t mean the Section 529 plan is bad. Section 529 plans are great! But if your income is high enough to worry about your state income tax bracket, then it’s not going to be worthwhile to pay student loans with your 529 plan.

In many cases, you’ll probably lose more value in the federal student loan interest deduction than you will gain by the state tax deduction for contributions.

You may be better off contributing to a Section 529, taking the state tax deduction, and putting the money towards something else:

  • A child’s or grandchild’s college education.
  • A niece’s or nephew’s college education.
  • A beneficiary’s K-12 private school education
  • Qualifying in-service or continuing education programs.
  • Graduate school tuition or lab fees.
  • Flight school.
  • An MBA program.
  • Expenses at any other qualified educational institution you’ve always wanted to take.

A qualified withdrawal for any of these purposes would still allow you to benefit from a state tax deduction for 529 contributions. But without causing an even greater reduction of your student loan interest deduction benefits.

Other Provisions of the SECURE Act

But if passed into law, the SECURE Act could have a number of other benefits, as well:

The age at which you must take distributions from IRAs would increase from 70 1/2 to 72. This lets tax-deferred retirement account contributions “cook” that much longer before retirees must begin taking distributions.

The bill would also allow seniors to continue making contributions to retirement accounts at older ages. This recognizes the fact that many seniors are working at older ages and are living longer into their retirement years.

The list of authorized penalty-free IRA “hardship distributions” would expand to include the birth or adoption of a child. You would be able to tap your IRA to access money to take some time off work with a new child. This without having to pay a 10 percent penalty on the withdrawal. You’d still have to pay state or federal income taxes on the withdrawal, however (except from Roth accounts).

The law would also expand the Section 529 benefit to include expenses related to apprenticeship programs.

Outlook

This bill has legs: The unanimous approval in the Ways and Means Committee indicates strong bipartisan support. And the Senate Finance Committee has introduced a companion bill, the Retirement Enhancement and Savings Act (RESA). This bill is also picking up steam on both sides of the aisle.

But don’t get too excited about the student loan repayment feature of the Section 529 plan if this passes. The bill has lots of laudable features, but the student loan payment benefit isn’t one of them.

*Tennessee’s income tax doesn’t affect wages, but does affect income from bond interest and stock dividends, etc.)

Also from Jason Van Steenwyk: Read This Before You Refinance Your Federal Student Loans.

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