Qualified tuition plans, also called 529 plans, allow money to grow tax-free and then, as long as you use the proceeds for higher education costs, it all comes out tax-free, too. While paying student loans you took out for college or graduate school may sound like a qualified higher education expense to most people, the Internal Revenue Service doesn't agree.
Typically, paying off student loans won't be a qualified expense for a 529 plan because you're not using the money to pay tuition, fees or other permissible expenses in the year that you incur them. The only way that you can count money taken from a 529 plan to pay off student loans as a qualified expense is if you took out the loans earlier that same year. For example, if you took out the loan in January 2013 to pay your spring semester classes, a 529 plan distribution used to pay those loans later in 2013 would qualify.
Though paying off student loans doesn't count as a qualified expense, the IRS won't stop you from taking money out of your 529 plan to pay them. However, you'll owe taxes on the earnings portion of your withdrawal, which is equal to the amount of earnings in your 529 plan divided by the 529 plan value times your withdrawal. For example, say you have $20,000 of contributions and $5,000 of earnings in your 529 plan and you take out $10,000 to pay for student loans. Divide $5,000 by $25,000 to get 0.2. Then, multiply 0.2 by $10,000 to find that $2,000 of your withdrawal is taxable.
You'll also owe a 10 percent early withdrawal penalty on the taxable portion of the withdrawal unless you qualify for an exception. For example, if $2,000 of the withdrawal is taxable, you owe a $200 penalty. Paying student loans doesn't count as an exception. However, if you inherited the 529 plan or you're permanently disabled, all your distributions from the 529 plan are penalty-free, even if you use them for student loan payments.
At the end of the year, you should receive a Form 1099-Q from the financial institution that holds your qualified tuition plan. It reports both your total distribution and the earnings portion. Assuming the earnings portion is taxable because you're using it to pay off loans, you must report it on line 21 of Form 1040, and it gets included in your taxable income for the year. The penalty is figured using Part II of Form 5329 and then copied over to line 58 of your Form 1040 tax return.
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