Here’s Why You Shouldn’t Tap 529 Plans To Repay Loans

Funds in 529 college-savings plans can be withdrawn without incurring taxes and penalties if they’re used to pay for qualified education expenses including tuition and fees, required books and supplies, and eligible room and board. But families should think twice before tapping these plans to repay student loans.

The Internal Revenue Service classifies student loans as nonqualified education expenses, and the earnings portion of nonqualified distributions is subject to ordinary income tax at the beneficiary’s rate plus an additional 10 percent tax penalty.

The cost of taking a nonqualified distribution from a 529 plan to pay down student debt -- not including the 10 percent penalty -- is up to about $750 per $10,000.

“If a family has been saving from birth, about a third of the distribution will be earnings,” he says. “If a family started saving in high school, about 10 percent will be from earnings.” So with earnings ranging between $1,000 and $3,000 on a $10,000 distribution, beneficiaries in the 15 percent or 25 percent tax brackets can figure on paying additional income tax of $150 to $750 per $10,000.

When a child first enrolls in college, the family should plan how it’ll pay for each year in school, ncluding how much will be distributed from 529 plans. “With careful planning, the family should not have 529 plan money left over and student loans,” .

Tom Fisher, founder and principal of Fisher Financial Strategies, a Cambridge, Mass.-based independent RIA firm, suggests that parents target saving for the first three years of college in a 529 plan. “You don’t want to over-save and have money you can’t take out penalty-free,” he says.

Fisher, who estimates he has helped nearly half his 150 clients plan for college, encourages them to revisit their college-planning decisions every few years, in the context of their overall financial plan, as their children grow up and their post-high school plans become clearer. To estimate college costs, he suggests using the expected family contribution (EFC) calculator on the College Board website and the net price calculators on the websites of individual schools.

He thinks it’s better to spend 529 funds first before kicking into borrowing mode—particularly if a child may drop out of school.

Should families accumulate excess funds in a 529 plan, there are some options. Remaining funds can be used later for graduate school. The IRS also permits parents to shift funds between their children’s 529 accounts, says Fisher, and to designate a different family member as the beneficiary. This includes a parent seeking additional education, or a future grandchild. If a child receives a scholarship, the parent can withdraw up to the amount of the award from a 529 plan without paying a penalty, although income tax will be owed.

Fisher encourages parents to discuss college interests, expectations and finances with their children. What’s needed is “more meeting of the minds,” he says, “before starting to fork over money.”