Can You Tap 529 Plan Funds to Pay Student Loan?

By College Planning Bankrate.com

Dear Dr. Don, 

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I'm considering whether to pay off the student loan I borrowed this year with some of my 529 plan funds. Will that affect the amount of student loans I'm eligible to borrow in the future?

Thanks, -- Dianne Debts

Dear Dianne, 

Good question! I asked Mark Kantrowitz of Edvisors.com, a college financing information site, about using funds from a 529 plan to pay off a student loan taken out in the current year. Here's what he had to say.

"Education loans are not considered qualified higher education expenses for a 529 college savings plan under current law. So there are two possible approaches:

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If the student is still in school, take a distribution from the 529 college savings plan for qualified higher education expenses and use the proceeds to pay down the debt. You may wish to note the interaction between 529 plan distributions and the American Opportunity Tax Credit. One cannot use a tax-free distribution from a 529 plan to pay for the same expenses that justify the American Opportunity Tax Credit. Coordination restrictions prevent this kind of double-dipping. So it is best to carve out $4,000 of tuition and textbook expenses to be paid for with cash or loans to qualify for the maximum American Opportunity Tax Credit. Thus, if you used loans to pay for expenses for which you claimed the AOTC, you cannot subsequently use a tax-free distribution from a 529 college savings plan to pay down that debt. Of course, this begs the question of how you will pay for the higher education expenses if the 529 plan distribution is going to pay down debt; if you have the cash to pay for the expenses, why not use that cash to pay down the debt? The main possibility is that the cost of attendance exceeds the actual costs, leaving some play in the joints where you can take a higher distribution and have some excess over expenses.

Take a nonqualified distribution to pay down the debt. Nonqualified distributions are subject to ordinary income taxes (at the beneficiary's rate) and a 10 percent tax penalty on the earnings portion of the distribution. If the earnings are minimal, the family might be willing to pay the taxes to reduce the student loan debt."

As to how reducing your student loan balance impacts your ability to take out additional loans, paying down federal student loan balances may restore part of the cumulative loan limits. But your borrowing capacity is also controlled by annual loan limits and possibly by your financial need. "Loan limits for graduate and professional school are different than loan limits for undergraduate school," Kantrowitz says. "Restoring undergraduate loan limits does not carry over to graduate school."

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