Rules for Using A 529 Account To Repay Student Loans

When the Secure Act passed in 2019, a new option opened up for excess balances left over in 529 accounts called a “Qualified Loan Repayment” option.  This new 529 distribution option allows the owner of a 529 to distribute money from a 529 account to repay student loans for the beneficiary of the 529 account AND the beneficiary’s siblings.  However, this distribution option is not available to everyone, and there are rules and limits associated with these new types of distributions.

State Level Restrictions

While the Secure Act made this option available at the Federal level, it’s important to understand that college 529 programs are sponsored at the state level, and the state’s allowable distribution options can deviate from what’s allowed at the Federal Level.  For example, specific to this Qualified Loan Repayment option, the Secure Act began allowing these at the Federal Level in 2019, but New York did not recognize these as “qualified distributions” from a 529 account until just recently, in September of 2024. 

So, if an owner of a NYS 529 account processed a distribution from the account and applied that amount toward a student loan taken by the beneficiary of the account, it often triggered negative tax events such as having to pay state income tax and a 10% penalty on the earnings portion of the distribution, as well as a recapture of the state tax deduction that was given from the contributions to the 529 account.  Fortunately, some states like New York are beginning to change their 529 programs to more closely match the options available at the Federal level, but you still have to check the distribution rules in the state that the account owner lives in before processing distributions from a 529 to repay student loans for the account beneficiary and/or their siblings.

$10,000 Lifetime Limit 

There are limits to how much you can withdraw from a 529 account to apply toward a student loan balance.  Each BORROWER has a $10,000 lifetime limit for qualified student loan repayment distributions. It’s an aggregate limit per child.  So, if the child has multiple 529 accounts that they are the beneficiary of, it’s an aggregate limit of $10,000 between all of their 529 accounts. This is true even if the 529 accounts have different owners. For example, if the parents have a 529 account for their child with a $30,000 balance and the grandparents have a 529 account for the same child with a $10,000 balance, there’s an aggregate limit of $10,000 between both 529 accounts, meaning parents cannot take a $10,000 distribution and apply it toward the child’s student loan balance, and then the grandparents distribute an additional $10,000 to apply to that same child’s outstanding student loan balance.

Sibling Student Loan Payments

In addition to being able to distribute $10,000 from the 529 and apply it towards the account beneficiary's outstanding student loans, the account owner can also distribute up to $10,000 for each sibling of the 529 account beneficiary and apply that toward their outstanding student loan balance.  The definition of siblings includes sisters, brothers, stepbrothers, and stepsisters.

Parent Plus Loans

If the parents took out Parent Plus Loans to help pay for their child’s college, after distributing $10,000 to repay student loans in their child’s name, they could then change the beneficiary on the 529 to themselves and distribute $10,000 to repay any outstanding Parent Plus loans taken in the parent’s name since the parent is considered a different “borrower”. 

Most but Not All Student Loans Qualify

Most Federal and private student loans qualify for repayment under this special 529 distribution option. However, there is additional criteria to make sure a private student loan qualifies for repayment.  The list is too long to include in this article, but just know if you plan to take a distribution from a 529 account to repay a private student loan, additional research is required.

Forfeiting Student Loan Interest Tax Deduction

If a distribution is made from a 529 account and applied toward a student loan, it may limit the taxpayer’s ability to deduct the student loan interest when they file their taxes. The student loan interest deduction is currently $2,500 per year.   Whether or not the distribution from the 529 will limit or eliminate the $2,500 tax deduction will depend on how much of the 529 distribution was made to repay the student loans cost basis versus earnings. 

Example: If a parent distributes $10,000 from their child’s 529 account and applies it toward their outstanding student loan balance, and $6,000 of the $10,000 was cost basis (what the parent originally contributed to the 529) and $4,000 was earnings, the earnings portion of the distribution is applied against the $2,500 student loan tax deduction amount. So, any distributions made from a 529 to repay a student loan with earnings equal to or greater than $2,500 would completely eliminate the student loan tax deduction for that year.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.