College Money Guru,
Can funds from a 529 plan be used to pay off student loans upon graduation?
Withdrawals from a 529 plan are tax-free to the
extent the account beneficiary incurs "qualified
higher education expenses," or QHEE. The
list of eligible expenses includes tuition, mandatory
fees, books, supplies, equipment and the expenses
of special needs beneficiaries. It also includes
a capped amount of room and board if the beneficiary
is at least a half-time student. However, QHEE
does not include student loan repayments.
Some may argue that student loans merely represent the expenses
incurred by the student in past years and should
be counted as QHEE when the loans are repaid.
The IRS apparently does not buy this argument
and will count a student loan only for the year
when the loan is taken out to pay the eligible
expenses, not for the year the loan is repaid.
Here's an example.
John graduates from college in May
2007. In January 2007, John paid $10,000 for his
final semester's tuition, fees, books, supplies,
and room and board. To make these payments, he
borrowed a total of $8,000 in federal and nonfederal
student loans and paid the rest with earnings
from a part-time job. John graduates from college
with a total of $30,000 in loans. In July 2007,
John's parents withdraw $30,000 from their 529
accounts (John is the beneficiary) so John can
pay off all of his loans and begin his post-college
life without debt.
John's qualified expenses for 2007
total $10,000 (the amount paid with cash and loan
proceeds). Of the $30,000 in withdrawals from
John's parents' 529 plan, $10,000 is a tax-free
"qualified" withdrawal and $20,000 is
a "nonqualified" withdrawal. The earnings
portion, but not the principal portion, of the
$20,000 nonqualified withdrawal is subject to
income tax and a 10 percent federal tax penalty.
The penalty is waived to the extent John received
any tax-free scholarships in 2007.