Can 529 money be used to pay student loans?

[zetta]

Just a hypothetical question here. Suppose you had a kid in college who wasn't keeping their grades up. In that situation I might want to tell the kid he'd have to take out student loans for the next semester and I'd make payments according to the grades he earned. Would I be able to make student loan payments from the 529 plan without penalty? Or does 529 money have to go directly to the educational institution?

[disneysteve]

My gut answer to this question was no. I did a little searching and found a possible maybe. One article says the IRS "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." They go on to give an example of a student taking out a loan in January and the parents taking money out of the 529 in July to repay that loan.

Here is the article:Joe Hurley's question and answers on 529 Plans

It appears that as long as the money is repaid in the year it was borrowed, that would qualify but you can't use 529 funds to repay money borrowed in prior years without triggering the penalty for non-qualified withdrawals.

[MonkeyMama]

It doesn't have to be "repaid in the year borrowed."

It just has to be taken from the 529 in the year the expenses are incurred. You could invest it or leave it in cash until you are ready to repay the loan.

Essentially, you can take money out of a 529, any year, equal to educational expenses incurred that year. It doesn't really matter what you do with the money when you take it out. But no, you can't take money out of a 529 plan, penalty free, for the sole purpose of repaying a student loan.

[disneysteve]

Originally Posted by MonkeyMama

Essentially, you can take money out of a 529, any year, equal to educational expenses incurred that year.

Does that mean the 529 money doesn't actually have to be used for educational expenses as long as there actually were educational expenses equal to the amount withdrawn? For example, could my kid borrow $5,000 for school and then I take $5,000 out of the 529 and use it to take a cruise?

[fruitbowlk]

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.

[disneysteve]

Originally Posted by fruitbowlk

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.

But it seems that if the money is borrowed in January and repaid from 529 funds any time within that same year, that would work.

[MonkeyMama]

Originally Posted by disneysteve

Does that mean the 529 money doesn't actually have to be used for educational expenses as long as there actually were educational expenses equal to the amount withdrawn? For example, could my kid borrow $5,000 for school and then I take $5,000 out of the 529 and use it to take a cruise?

Okay, now you are making me think!

It seems it would be okay, since everything I see is that it is okay to pull the money out for educational expenses, even if a loan is used to pay for them.

I think the point is, you have to pay the loan eventually. So it doesn't really matter what you do with the money until the loan is paid.

I think the issue in your scenario is that is the student holds the loan, and the student is the beneficiary of the 529, no, I don't think the parent can go on the cruise. If the parent holds the loan, and is responsible for paying it off, then yes, the parents can use it for whatever they want. That is my gut feel. You can't stick the kids with the loans, and then withdraw the money for your pleasure - that is not the intent anyway.

I don't think this comes up much at all. Most people "pay as they go" with a 529 plan. Thus, there isn't much professional discussion on the topic, that I can see. But yes - a good question.

[disneysteve]

Originally Posted by MonkeyMama

I don't think this comes up much at all. Most people "pay as they go" with a 529 plan. Thus, there isn't much professional discussion on the topic, that I can see. But yes - a good question.

I think the issue is that some parents want to put conditions on paying for college, like you have to maintain a B average for us to pay, or something like that. Since you have to pay the bill first, this would mean the student could borrow the money and then the parents could repay the loan with the 529 funds once the grades were known for the semester.

If the required grade average wasn't achieved, the parents could take out the money from the 529 (since there were qualified expenses) but then keep the money for themselves, leaving the student to repay the loan.

[MonkeyMama]

Originally Posted by disneysteve

I think the issue is that some parents want to put conditions on paying for college, like you have to maintain a B average for us to pay, or something like that. Since you have to pay the bill first, this would mean the student could borrow the money and then the parents could repay the loan with the 529 funds once the grades were known for the semester.

If the required grade average wasn't achieved, the parents could take out the money from the 529 (since there were qualified expenses) but then keep the money for themselves, leaving the student to repay the loan.

I don't think that scenario would fit in the rules. Quite simply, the money would never go to college expenses then.

BUT, definitely seems like a bit of a grey area, and one I don't see much guidance on.

[disneysteve]

Originally Posted by MonkeyMama

I don't think that scenario would fit in the rules. Quite simply, the money would never go to college expenses then.

BUT, definitely seems like a bit of a grey area, and one I don't see much guidance on.

What I was wondering is how do they (whoever "they" is) track what you do with the money that you withdraw from the 529. What documentation do you have to provide, if any? How do you have to document that the amount you take out matches the expenses incurred?

[MonkeyMama]

Steve - colleges send statements to the IRS (kind of like a 1099) that details "qualified expenses" any student incurs in a year. (Though it certainly wouldn't be all inclusive).

529 withdrawals are also reported to the IRS. So there is a matching system there. IF something is really out of whack, the IRS may take notice.

As with most anything, it wouldn't be looked at closer unless you were audited. But you would want to keep good records in case of audit.

The 529 custodian probably just has you fill out a simple form when you withdraw funds, to help determine tax treatment of the withdrawal. It's the same way with IRAs, etc.

[disneysteve]

Originally Posted by MonkeyMama

Steve - colleges send statements to the IRS (kind of like a 1099) that details "qualified expenses" any student incurs in a year. (Though it certainly wouldn't be all inclusive).

529 withdrawals are also reported to the IRS. So there is a matching system there.

So college sends IRS statement saying my kid had qualified expenses of $5,000.

529 plan sends IRS statement saying I withdrew $5,000 from my account.

Is that it? Is there any report documenting that the 529 money actualy went to the college?

[Like2Plan]

Originally Posted by disneysteve

What I was wondering is how do they (whoever "they" is) track what you do with the money that you withdraw from the 529. What documentation do you have to provide, if any? How do you have to document that the amount you take out matches the expenses incurred?

We receive a 1098-T from the college for qualified tuition and related expenses--however, they don't report room and board on this form.

We receive a 1099-Q from the 529 plan which gives the gross distribution and breaks it down by earnings and the basis.

The paperwork that we receive says we are responsible for making sure we are only drawing money for qualified expenses and we have to keep receipts for 3 years for the IRS (I'm assuming 3 years means 3 years from the date your taxes are due--or 3 years from when you file whichever is later for any given return. )

[Like2Plan]

Originally Posted by disneysteve

So college sends IRS statement saying my kid had qualified expenses of $5,000.

529 plan sends IRS statement saying I withdrew $5,000 from my account.

Is that it? Is there any report documenting that the 529 money actualy went to the college?

The paperwork we have received does not match up because they don't include room and board and books on the 1098T. I believe this year, the IRS is also allowing a computer (I have to check on that). You can buy your books anywhere, so the school wouldn't have any way to report what you spent. (I don't know why they don't include room and board since it is paid to the school. )

I have a feeling the forms will evolve as time goes on.

[MonkeyMama]

Originally Posted by disneysteve

So college sends IRS statement saying my kid had qualified expenses of $5,000.

529 plan sends IRS statement saying I withdrew $5,000 from my account.

Is that it? Is there any report documenting that the 529 money actualy went to the college?

No.

Think about your taxes - do you have to "prove" everything you do to the IRS? Are you thinking of circumventing the rules because they will never know?

That being said - of course you would keep your own financial records that you paid the college, for any potential audit.

[MonkeyMama]

Originally Posted by Like2Plan

The paperwork we have received does not match up because they don't include room and board and books on the 1098T. I believe this year, the IRS is also allowing a computer (I have to check on that). You can buy your books anywhere, so the school wouldn't have any way to report what you spent. (I don't know why they don't include room and board since it is paid to the school. )

I have a feeling the forms will evolve as time goes on.

Precisely. I mentioned that the 1098T was certainly not all inclusive. The IRS is certainly aware - it's not like you will get audited because you withdrew a reasonable amount for room and board.

[Taxplanr]

Zetta, your scenario is one of the reasons why I am always hesitant for parents to use a 529 in the first place. They are much better for grandparents to use and do not hurt when qualifying for grants and aid when held by the grandparent.

[Alex_Adviser]

Originally Posted by zetta

Just a hypothetical question here. Suppose you had a kid in college who wasn't keeping their grades up. In that situation I might want to tell the kid he'd have to take out student loans for the next semester and I'd make payments according to the grades he earned. Would I be able to make student loan payments from the 529 plan without penalty? Or does 529 money have to go directly to the educational institution?

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.

[disneysteve]

Originally Posted by Alex_Adviser

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.

Alex, see the link I gave in post #2 above. As I read that, it says that you could use 529 funds to repay a student loan as long as you do so in the year in which the expenses were incurred.

[jIM_Ohio]

Originally Posted by disneysteve

Does that mean the 529 money doesn't actually have to be used for educational expenses as long as there actually were educational expenses equal to the amount withdrawn? For example, could my kid borrow $5,000 for school and then I take $5,000 out of the 529 and use it to take a cruise?

DS-

I liked MM's response, and will add that HSA's work the same way... more or less.

The 529 is an account you withdraw from. The IRS decided on April 15 or when you file taxes if the withdraw was qualified. It does not track "every" receipt, just looks at a macro view of your yearly balance sheet.

For example in June if you pay a deposit of $2000 to a college for freshman year, then at Orientation in August pay another $8000, you have $10,000 of "qualfied" educational expenses for that year. If you withdraw $10,000 from a 529 and put in your checking account on Dec 24, then head to vegas for new years eve and blow all the 10k, the IRS books balance, they have no issue with
a) was a student load used to pay the 10k?
b) the time of year the 10k was taken from the 529
c) what the 529 was invested in at any time

HSA's are similar
as I read the HSA documents, I know we incurred 6k+ of health care expenses in Jan-Feb-Mar of 2009. Our HSA does not get its $6000th dollar of contribution until December. We may not withdraw the 6k until 2010 or later...

what my tax return will show is
6k of qualfied medical expenses
6k of HSA withdraws

in whatever year I take the money out of the HSA.