How to Combine Secure Act, 529 Plan and PSLF Benefits into One Smart Strategy

Congress recently passed the SECURE Act, aka Setting Every Community Up for Retirement Enhancement. (Wow! They really try to make those acronyms work, don’t they?)

This act was mainly aimed at updating some laws for retirement plans, including:

• Increasing the age at which someone is required to take a distribution from their retirement plan from 70½ to 72
• Repealing the maximum age to make a contribution to a retirement plan
• Allowing long-term, part-time employees to participate in employer retirement plans

When it comes to paying for college, the SECURE Act also expanded what is considered a qualified distribution from 529 plans. This aspect of the SECURE Act is what can become part of a smart financial strategy.

First things first though.

What is a 529 Plan?

A 529 plan is a type of account to help fund current and future college and educational expenses. Because the funds can only be used for this specific purpose, the plan comes with tax benefits. Think of a 529 plan as a Roth IRA for education. There are rules and limitations on how much can be put in and in what cases funds can be distributed.

Every 529 has an account holder and an account beneficiary. They can be the same person, though they are often different, such as a parent saving for a child. The account holder can make a contribution to a 529 plan with after-tax money. Once it’s in there, the money can be invested and grow tax-free. The account holder can take money out tax-free to pay for a qualifying education expense for the beneficiary.

It’s a pretty good deal, especially because of the potential tax deduction on the front end and then letting the funds grow tax-free.

Each state may have different rules as to how much money can be put in and distributed, as well as rules about whether the contributions will qualify for a tax-deduction on the state tax return. There is no tax deduction on the federal tax return.

The SECURE Act was passed by the federal government, but it is up to each state to decide whether to adopt it or not. Most states have adopted or will adopt it, but you should check with a tax professional and the 529 plan account servicer to confirm how the laws apply in your specific state.

As it relates to student loans, the SECURE Act now makes it possible to take money from a 529 and put it toward student loan repayment. There are limits on how to go about this, however.

How do I contribute to a 529 plan?

To contribute to a 529 plan, you first need to set one up. 529 plans are state-sponsored, so they can be different from state to state. You don’t necessarily have to use your state’s 529 plan, however.

Work with a competent tax professional before making contributions or distributions to a 529 plan.

How to make student loan payments with a 529 plan

Historically, 529 plan distributions could only go toward paying for current schooling. The SECURE Act changed that. Now people can make student loan payments with 529 plan distributions.

Money from a 529 can only be used for a “qualified higher education expense.” Over the years, the government has expanded that definition. It used to mean simply paying tuition. Then, it was expanded to include books and other supplies.

Here is the verbiage from the SECURE Act on the expansion of what a qualified higher education expense is and how someone can use money from a 529 to pay student loans:

TREATMENT OF QUALIFIED EDUCATION LOAN REPAYMENTS.—

“(A) IN GENERAL.— Any reference in this subsection to the term ‘qualified higher education expense’ shall include a reference to amounts paid as principal or interest on any qualified education loan (as defined in section 221(d)) of the designated beneficiary or a sibling of the designated beneficiary.

“(B) LIMITATION.—The amount of distributions treated as a qualified higher education expense under this paragraph with respect to the loans of any individual shall not exceed $10,000 (reduced by the amount of distributions so treated for all prior taxable years).

Unless you’re an attorney or have read through stuff like the before, you’re probably saying, “Huh?” Here’s what it means:

The main point is that the SECURE Act expanded the definition to include “amounts paid as principal or interest on any qualified education loan,” meaning money can be distributed from a 529 plan to make student loan payments.

The “limitation” verbiage is important too. The maximum amount of 529 plan money that can be used to pay back student loans is $10,000. In other words, someone can put up to $10,000 from a 529 toward student loan payments. This distribution can be made over time or in one lump sum, but once you use $10,000, that’s it.

This option could be helpful for people who have money in 529 plans but are all done with school. Before the SECURE Act, their only option to access that money was to take it out, then pay taxes and a penalty. They’d lose 30% to 50% of the value by doing that. Now, however, they can use up to $10,000 of it to put toward their student loans tax and penalty-free.

What is a qualified education loan?

What loans can be paid from a 529 plan? There’s some gray area here, and I’m a Certified Financial Planner, not a legal professional, but let’s take a look at the definition of a qualified education loan from the Internal Revenue Code:

“The term ‘qualified education loan’ means any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses.

Such term includes indebtedness used to refinance indebtedness which qualifies as a qualified education loan.”

It appears that both federal and privately refinanced student debt are qualified educational loans. The definition specifically excludes money owed to a “related” person, and there are some other caveats, so check out the exact verbiage from the link above.

How to get state tax benefits from a 529 plan by making student loan payments

I was talking with my wife about the SECURE Act, 529 Plans and student loan repayment, and she astutely asked the question, “If someone still has money in their 529, why would they have student loans?” It’s a great question.

The answer is that many people with student loans don’t have any money in a 529 plan. Even so, they could still take advantage of this.

Why would someone put money in a 529 plan just to pay it right out for student loan payments?

There’s really only one reason: the state tax deduction.

For example, I live in St Louis, Mo. Our state tax rate is 6%. If my wife and I put $10,000 away in a 529 plan, I could take a $10,000 deduction on my Missouri state taxes and would get $600 back on my tax return. There is currently no federal tax deduction for this.

Like I said though, be sure to check with a qualified accountant familiar with your state’s tax rules. If your state doesn’t offer the deduction on your contributions, then it probably doesn’t make sense to set one up and fund it specifically to do this. For example, California does not give a tax deduction for 529 plan contributions, so there might not be an upside to this for California residents.

But if your state does offer a tax deduction, you can figure out if it’s worth it to you. If you’re a financial optimizer, this strategy is free money, so take it.

If it’s worthwhile for you to open up a 529 plan just to make student loan payments, you could set up an account on which you are both the account holder and the beneficiary of the plan. That way you can fund it and also take the distributions for your benefit.

What’s the best way to use those funds? It depends on whether you’re taking an aggressive approach or going for loan forgiveness. Let’s talk about how someone can optimally use money in a 529 to make student loan payments in each of those scenarios.

SECURE Act, 529 plans and student loan refinancing

The goal of refinancing is to pay off the loans as fast as possible and pay as little interest as possible. Ideally, this would mean taking up to $10,000 in one lump sum, the maximum distribution allowed from a 529, to pay down the loans as soon as you have the money.

What if you have some money in a 529 plan but not $10,000? Use what you have and pay down as much of the loans as you can. Earmark it toward your highest interest rate debt.

Once that’s done, refinance if you can lower your interest rate (and potentially get a cash-back bonus from Student Loan Planner®). Make contributions into the 529 plan monthly and turn right around and make student loan payments from the account.

Remember the $10,000 limitation, so just be sure that the initial lump sum payment and all subsequent student loan payments total $10,000 and not $1 more.

SECURE Act, 529 plans and PSLF or income-driven repayment

The goal of income-driven repayment with or without PSLF is to put as little toward your loans as possible and maximize loan forgiveness. What this means when you’re on an IDR plan is that you do not want to make any lump-sum payments from a 529 plan toward your student loans.

Instead, take distributions from the 529 plan in the exact amount of your monthly student loan payments and not one penny more. If your monthly payment is $503, then you take $503 out each month to make the payment.

If your 529 Plan has a $0 balance or you’re just starting your 529 Plan, you could simply contribute your monthly payment into the 529 plan first, then take that money and distribute it to make your student loan payment.

There are a couple things to know here:

• The distribution has to happen in the same year as the expense. You can’t, for example, take out money in December to make a payment in January of the next calendar year.
• State laws vary, but the money needs to sit in the account for seven to 10 days before it can be distributed; otherwise the contribution may not be eligible for the state tax deduction. For example, let’s say that someone has a $500 PAYE payment. They could put $500 in two weeks ahead of the actual payment and then take the distribution and send it to their loan servicer. Again, check with a competent CPA and with your 529 plan account servicer before making any moves.

Is a 529 plan worth it to make student loan payments with the SECURE Act?

If you have any money in a 529 plan for which you are the beneficiary, then using your 529 to make student loan payments is definitely worth. It would also be worth it to use that money to pay down your loans before you refinance.

If you don’t have any money in a 529 plan right now, check with your local state plan and a tax professional to see if you’d be eligible for a state tax deduction and any other state specific requirements. Then you have to ask yourself, “Is the juice worth the squeeze?” Is it worth it to take the time to get the potential state tax deduction?

Either way, this is yet another way that Congress is trying to make student loan repayment more accommodating. We’ll have to wait and see what they do next.

This content is not considered tax or legal advice. Consult a qualified tax professional and your state’s 529 plan professionals to find out how the SECURE Act could work for you in your state.