My D is a sophomore and received scholarships and financial aid that covered most of her college costs. She has received subsidized loans and we have been accepting them instead of paying out the money from our 529 account since the money will not accrue interest until she graduates. She is intending to attend graduate school and will likely not be getting a scholarship (she wants to be a Physical Therapist) so this probably won’t be an issue. But, if on the outside chance a miracle occurs can 529 funds be used to pay the subsidized loans she has received or will we just have to take the hit on taxes for using the funds on non qualified expenses?
No, 529 funds cannot be used to pay off loans.
Yes, 529 funds can be used to pay off loans – kind of. If a loan was used to pay qualified expenses, you can take a 529 distribution until the end of that year, not to exceed the amount of the qualified expenses, and use that distribution to pay off the loan, without incurring any taxes on the earnings part of the distribution. The key is that all this must happen in the same calendar year, and the total of all the 529 distributions cannot exceed the amount of qualified expenses paid in the same year. Otherwise, you’ll end up with a taxable non-qualified distribution.
@lvvcsf, @AroundHere While paying loans is not a qualified educational expense, withdrawals from 529 accounts equal to scholarships received can be made. However, it is my understanding that you need to withdraw the funds in the same tax year(s) the scholarship(s) are received. In essence, one could take withdrawals from the 529 equal to the scholarships and then use those funds down the road to pay the loans, right?
“If your child receives a scholarship you might not need all the money you’ve saved up in your 529 plan for college expenses. You generally have three options at that point. The first is to earmark the 529 funds for some future use by that child, perhaps for graduate school. The second is to direct it to another family member, such as a current sibling or a future grandchild. You can make the change in beneficiary anytime before the second family member actually goes to college. The third option is to withdraw the extra funds. The earnings in your account will be subject to income tax either on your return or your child’s. Normally, there would be a a 10% additional federal tax on the earnings portion as well, which is penalty for taking a nonqualified withdrawal, but the penalty is waived when scholarships are the reason for it. In effect, the scholarships have turned your tax-free 529 investment into a tax-deferred 529 investment. Of course, many parents will still be able to use their entire 529 balance on other non-scholarship expenses such as room and board, books, and supplies, and so the scholarships received by their children will not lessen the tax benefit of the 529 plan.”
Not exactly. See my post above.
There is no IRS guidance I am aware of that requires the 529 distribution due to a scholarship received to take place in the same year that the scholarship is applied to qualified expenses.
The big problem here is that a 529 distribution taken in response to a scholarship will incur taxes on the earnings portion of the distribution (although the 10% additional tax should be waived). The idea is to avoid paying taxes on any 529 distribution, if at all possible.
Thank you. I am guessing she will need to borrow money for her DPT program. The idea behind accepting only the subsidized loans was that I believe the interest doesn’t accrue until she is no longer enrolled in school. Using the 529 money to pay for grad school means a bit less interest. If I am misunderstanding this please correct me.
You are correct. If she needs money for grad school, it is best to keep those subsidized loans. The govt is paying the interest on them until she is done with school. It will be best to use the 529 money for grad school. If she gets a scholarship for grad school, you could pull out the amount equaling the scholarships yearly and use that to pay the loans when she graduates.
A 529 account owner can always pull the money out of the account, and use it for whatever they want. The goal is to do it with the smallest possible tax hit. Taking a distribution because of scholarships will save you the 10% additional tax, but you’ll still pay regular income tax on the earnings. Depending on a variety of factors, there might not be much difference financially between taking a standard non-qualified distribution, and taking a distribution based on a scholarship.