The SECURE Act and Student Loan Repayments: The Gift of Options
Becca Craig, ABA, 2/4/2020
Much of the discussion surrounding the recently passed SECURE Act focuses on employer-sponsored retirement plans, IRAs and inherited IRAs. Yet, tucked away in the new law – which aims to expand access to retirement savings vehicles, preserve retirement savings, and encourage better savings habits – is the expansion of what counts as a qualified education expense under the rules governing 529 college savings plans. While the section explaining these new allowances encompasses less than a page of text, the implications and benefits could be far-reaching, both for families saving for college and for families struggling to pay off student loans.
In short, the SECURE Act allows owners and beneficiaries of 529 plans to distribute an aggregate lifetime limit of $10,000 in qualified student loan repayments. That means parents or other family members may keep contributing to a student’s 529 plan throughout college or even after graduation and then use those funds to repay student loans tax-free.
Important Considerations
While the SECURE Act is a federal law, the regulations surrounding 529 plans are highly state dependent, making it extremely important to understand the rules for the specific state in which a 529 plan was opened. In all, more than 30 states offer residents a state income tax deduction or credit for making contributions to a 529 plan. Some states allow the immediate withdrawal of 529 plan funds, so you can use the account as a pass-through, while others require the money to remain in the plan for a certain period of time before it can be distributed.
Additionally, the IRS says you can only reimburse yourself from a 529 plan in the year an expense was incurred. Repaying up to $10,000 of student loans in any given year meets this standard.
The final thing to remember is that you can’t double-dip on tax benefits. If you use a 529 plan distribution to repay student loan interest tax-free, you can’t then claim the student loan interest deduction for those same repayments when you file your income tax return. The student loan interest deduction, which has an annual maximum of $2,500, phases out at certain income levels, so weigh the relative merits of each strategy on a case-by-case basis. Because married couples must file their taxes jointly to receive the student loan interest deduction, unfortunately spouses can’t file separately for one to claim the deduction while the other uses the newly qualified 529 plan distribution. 529 plan distributions can also affect your ability to claim other education tax credits and deductions, like the American Opportunity Tax Credit and lifetime learning credit, so it is important to consult your tax professional.
Still, if any of the following situations sound familiar to you, it could be worth a deeper look at how the SECURE Act may affect your student loan repayment plans.
You’re currently paying off student loans using a standard repayment plan. Broadly, 529 plan distributions can now be used to reimburse beneficiaries for either loan principal or loan interest paid (so long as the distribution and repayment occur in the same year). The SECURE Act, however, does not require that a 529 plan be open for a minimum time to make qualified distributions toward student loans. You could in theory open a 529 plan and contribute tax-advantaged funds to immediately or eventually (it comes down to the state) distribute for repaying your own student loans. This is similar to how some 529 plan owners make annual, lump-sum contributions to reap state income tax credits, then right away use those funds to pay K-12 private school tuition (but again, only in states that permit this process and offer tax benefits for doing so).
If your end goal is to get rid of student loans as soon as possible, using a 529 plan as a vehicle to make lump-sum payments against your loan principal might make sense for you.
You are enrolled in the Public Service Loan Forgiveness (PSLF) program. Due to the PSLF program’s 120-payment requirement, lump-sum payoffs most likely are not the best route in this case. If you are pursuing federal student loan forgiveness in exchange for public service, continue making your scheduled monthly income-based repayment. The SECURE Act allows you to do so using tax-advantaged funds from a 529 plan – perhaps one opened for that purpose – until the $10,000 lifetime cap is met. Reimbursements from a 529 plan can be made at any time during the year, monthly, annually or sporadically.
You are saving in a 529 plan for the benefit of another. The SECURE Act adds a rule permitting loan repayments for the 529 plan’s beneficiary plus $10,000 in loan repayments for each of the beneficiary’s siblings. Siblings include a brother, sister, stepbrother or stepsister, but a 529 plan account owner may change the plan beneficiary at any time without tax consequences.
Next Steps
If you or a family member were hesitant to withdraw money from an old 529 plan for non-qualified purposes because of the 10% penalty, consider making a now-qualified distribution to repay student loans. If you’re currently making payments toward qualified student loans, consider opening and funding a 529 plan if your state offers state-level income tax benefits.
Make sure you understand the SECURE Act’s most recent interpretations and what steps you can take to maximize its advantages. Start a conversation with your wealth advisor and your tax professional about your unique financial situation and the role student loans may play in it.
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