The enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act marked one of the larger shifts in retirement and financial planning in recent history. The new law, which went into effect January 1, 2020, contains numerous elements that affect average Americans. One such provision allows you to use 529 savings plan funds to repay qualified education loans, with a lifetime limit of $10,000 per beneficiary.
This new section of the law appears to be even more enticing for taxpayers who live in a state that offers a tax benefit for contributions to a state-sponsored 529 savings plan. Currently, over 30 states and the District of Columbia offer an incentive for electing to save in a 529, either by offering a deduction or a credit. Indiana, as an example of a more generous state, offers a 20% credit on up to $5,000 in contributions per individual, or a maximum tax savings of $1,000 in the year of contribution.
Should you take advantage of the new lifetime limit?
With this new law, many people are attempting to take advantage of the new $10,000 lifetime limit. Taxpayers are considering contributing the full allowable amount to maximize their state deduction or credit — and then immediately using those funds to pay down their student loan debts.
In the Indiana example, the taxpayer would contribute the maximum $5,000 per year to their 529 savings plan to capture the credit, then use those funds to pay their education debt obligations. If the taxpayer did this for two consecutive years, thus hitting the federal lifetime limit of $10,000, they could receive a $2,000 tax credit from the state for paying down $10,000 of student loans. In states that offer 529 incentives, it is clear why residents would want to pursue these potential savings.
However, immediately trying to capture this tax advantage may be ill-advised until more clarity is available in this rapidly changing landscape. The SECURE Act is a federal statute, and we’ll need additional guidance from individual states to understand how each state will interpret the new law.
As an example, we can look at the last major update to 529 distributions: the Tax Cuts and Jobs Act (TCJA) enacted in 2017. The TCJA allowed for qualified distributions from a 529 for K-12 expenses; however, many states opted not to comply with the new standard, including some of the more heavily populated states. In addition, some states have strict standards for what may be classified as a qualified education expense.
At this point, we can only make assumptions as to how individual states will interpret the law. For example, some states might classify a 529 contribution that is immediately withdrawn to pay student loan debt as a non-qualified distribution. Others may require recapture of the prior year deduction if a distribution is made from the plan. Individual states could also enact laws that require a minimum holding period for 529 contributions.
For now, patience is the prudent path
Could the SECURE Act help with reducing your student loan balances? Sadly, the current answer is maybe. With student loan debt topping well over a trillion dollars, it’s possible that states will allow their residents to take advantage of the federal provision allowing payment of student debt with 529 funds while simultaneously capturing state incentives offered for contributing to a qualified 529 plan. However, it is also possible that individual states will pass legislation that classifies these distributions as non-qualified, thus potentially subjecting them to both tax and penalty consequences.
For the time being, the sound advice is to simply keep track of the developments in your own state and consult with your tax advisor before making a decision that could impact your tax situation.
How CLA can help
Laws that impact your financial future are constantly shifting, which is why you need a professional who can help you navigate an uncertain landscape. When it comes to the SECURE Act, we can help you understand how your decisions affect any existing or future student loans.