/ Legislation

Allowing 529 Money for Student Loans is Well Intentioned But Ill Conceived

Three days ago the House Ways and Means Committee passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. I don't normally discuss bills, only laws, because I don't like to speculate on bills.

While I support many aspects of this bill, there is a portion of this bill that is ill conceived, and needs to be addressed before it possibly becomes law. This bill would expand the tax and penalty free use of 529 money for student loans. (If you're not familiar with 529s, I have an overview here).

The Bill Text

Unfortunately, as of this writing, the bill is not available on the Congress.gov page, but the House Ways and Means committee did put out a copy of the bill here.

The portion of interest is as follows

(1) IN GENERAL.--Section 529(c) of such Code, as amended by subsection (a), is amended by adding at the end the following new paragraph:

‘‘(9) TREATMENT OF QUALIFIED EDUCATION LOAN REPAYMENTS.—

‘‘(A) IN GENERAL.—Any reference in this subsection to the term ‘qualified higher education expense’ shall include a reference to amounts paid as principal or interest on any qualified education loan (as defined in section 221(d)) of the designated beneficiary or a sibling of the designated beneficiary.
‘‘(B) LIMITATION.—The amount of distributions treated as a qualified higher education expense under this paragraph with respect to the loans of any individual shall not exceed $10,000 (reduced by the amount of distributions so treated for all prior taxable years).
‘‘(C) SPECIAL RULES FOR SIBLINGS OF THE DESIGNATED BENEFICIARY.—

‘‘(i) SEPARATE ACCOUNTING.—For purposes of subparagraph (B) and subsection (d), amounts treated as a qualified higher education expense with respect to the loans of a sibling of the designated beneficiary shall be taken into account with respect to such sibling and not with respect to such designated beneficiary.
‘‘(ii) SIBLING DEFINED.—For purposes of this paragraph, the term ‘sibling’ means an individual who bears a relationship to the designated beneficiary which is described in section 152(d)(2)(B).’’.

(2) COORDINATION WITH DEDUCTION FOR STUDENT LOAN INTEREST.—Section 211(e)(1) of such Code is amended by adding at the end the following: ‘‘The deduction otherwise allowable under subsection (a) (prior to the application of subsection (b)) to the
taxpayer for any taxable year shall be reduced (but not below zero) by so much of the distributions treated as a qualified higher education expense under section 529(c)(9) with respect to loans of the taxpayer as would be includible in gross income under section 529(c)(3)(A) for such taxable year but for such treatment.’’.

The Problem: Double Counting of Expenses

This would allow you to use 529 money tax and penalty free for both the principal and interest payments of student loans. The issue here is it lets you double count expenses.

Suppose Jane is in her last semester of college. She has $15,000 of qualified higher education expenses (QHEE) in 2019. Her parents had oversaved for her college education, and have $25,000 left in her 529. Her parents withdraw $15,000 from her 529 tax and penalty free for these QHEEs (which they rightfully can under the current law). But, Jane also takes a $10,000 student loan, and uses this $10,000 to pay for her tuition this semester. 529 money withdrawn tax and penalty free does not have to be paid directly to the school, so long as there is a corresponding QHEE. Jane then pays the $10,000 student loan immediately upon graduation. If this bill were to become law, then the last $10,000 in the 529 could be earmarked for this student loan and withdrawn tax and penalty free.

This legislation would create a loophole that is not in line with the intent of a 529. The following is an even worse example of how someone can take advantage of this loophole:

John has some money in a 529 that he would like to withdraw tax and penalty free. He enrolls at a local community college that has a tuition refund policy (get a full refund of expenses if you withdraw within a week of the start of classes). He then gets approved for a student loan and then withdraws from the college, leaving him with no actual tuition expenses, but a student loan that he can use for the tax and penalty free withdrawal of up to $10,000 of 529 money.

The Fix: Remove "Principal" and Only Allow Interest Payments

One could fix this by trying to track the expenses already paid for directly with 529 funds, and only allow 529 funds to be used towards student loan payments that correspond to expenses not already paid for with 529 funds. However, this is needlessly complicated.

You can instead fix this very easily by only allowing 529 money to be used tax and penalty free for the interest portion of student loan payments.

The fact that this this provision would be subject to a lifetime limit of $10,000 per individual mitigates this problem, but it still doesn't solve it.

Allowing 529 Money for Student Loans is Well Intentioned But Ill Conceived
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