You might get a tax surprise if you use this account to repay student loans

Personal Finance

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Student loan borrowers who want to repay the balance owed with their 529 college savings plan should think twice.

President Donald Trump signed the Secure Act into law last week. It will take effect on Jan. 1.

In addition to changing the way you save for retirement, the legislation also allows you to use up to $10,000 from your 529 college savings plan to repay your qualified education loans. This $10,000 limit applies over the lifetime of the plan’s beneficiary.

A 529 plan allows families to save after-tax dollars for educational costs. Your contributions grow tax-free, and you can tap the account tax-free if the money goes toward qualified educational expenses.

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There’s a sweetener, too. In all, 34 states and Washington, D.C., offer residents a state income tax deduction or credit for stashing money in a 529 plan, according SavingforCollege.com.

Here is where taxpayers can get tripped up: While the federal government has blessed using your 529 plan to repay student loans, the question is now whether states will follow their lead.

Some states have limited allowable uses of 529 plans to “qualified higher education expenses,” including tuition, fees, textbooks and supplies at a post-secondary school.

That means, depending on where you reside and how your state interprets the Secure Act, you may face the risk of your state clawing back tax incentives and hitting you with income taxes and penalties if you use your 529 savings to help pay down student loans.

“We’re still working on it; our lawyers are doing a legal analysis and determining whether changes need to be made on our end,” said Jennifer Freeman, director of communications for the New York State comptroller’s office.

“They are expecting to have that analysis done soon,” she said.

Federal vs. state

United States President Donald J. Trump signs the Tax Cut and Reform Bill in the Oval Office at The White House in Washington, DC on December 22, 2017.

Brendan Smialowski | AFP via Getty Images

This isn’t the first time that the federal government has expanded the use of college savings plans.

When Trump signed the Tax Cuts and Jobs Act in late 2017, the federal law allowed taxpayers to tap these accounts for K-12 private school tuition.

In all, 37 states and Washington, D.C., went along with the federal code, permitting residents to use their college savings tax-free to cover elementary and secondary tuition expenses.

The states are Alabama, Alaska, Arizona, Arkansas, Connecticut, Delaware, Florida, Georgia, Idaho, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Mississippi, Missouri, Nevada, New Hampshire, New Jersey, North Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, Washington state, West Virginia and Wisconsin, according to SavingforCollege.com.

Other states didn’t go along.

In New York, Oregon and Vermont, using a 529 plan for K-12 tuition would subject residents to a recapture of their state deduction.

Some — including Oregon and California — tack on penalties and taxes on earnings withdrawn for these so-called “nonqualified distributions.”

It remains to be seen how states might treat the use of 529 dollars to pay down student loan debt, especially since the law is so new.

“Some states automatically follow the federal definition, but others may pass supplemental laws and say the money is only for repaying college and not student loans,” said Mark Kantrowitz, publisher and vice president of SavingforCollege.com.

Proceed cautiously

Instead of socking away money in your 529 plan for the express purpose of grabbing a deduction and paying down a loan, wait and see how your state proceeds.

Here are a few points to consider:

Call your accountant. “Are you in a state that will cause you harm if you use the money for loans?” asked Ross Riskin, CPA and assistant professor of taxation at The American College of Financial Services. “Is there a benefit at all to you for contributing?

“Know your state’s impact and consult with your advisor about that.”

Coordinate with other tax benefits. There’s already an existing deduction for student loan interest, and you don’t even have to itemize your federal tax return to get it. If you tap your 529 plan to pay college loans, you won’t be able to claim this deduction.

“The new law has a provision that says you can’t double-dip,” said Riskin.

Think about how you’re investing. Many 529 plans include target-date funds that become increasingly conservative as a child approaches college age. Rethink your allocation if you’re using the funds for K-12 or to repay loans.

“You have some families who plan on using the money for private high school and might be overallocated toward equities,” said Riskin. “If you’re using it to repay student loans much later, you might be too conservative.”

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