Qualified expenses and 529 plans

Question: We have a 529 plan and also the option to take out a subsidized Stafford loan. Does it make sense to take out the loan and leave the 529 money alone, then pay off the Stafford loan after graduation? (I'm thinking that the 529 would still collect interest for a few more years, while there is now interest on the loan for a few more years.) If it does make sense, what would it do to the financial aid package for following year? The thinking is: Is it better to have debts (taking out a loan) or have less money invested (taking out money from the 529)? Thank you! Gabrielle, St, Paul, MN

Answer: Your idea seems reasonable. I remember thinking maybe we would do something along those lines when we opened up a 529 plan when our kids were young.  Problem is, the strategy doesn't work. Here's why: 

One of the many attractions of saving for college with a 529 plan is that the money compounds on a tax-deferred basis and redemptions are tax-free, as long as the money is used to pay for "qualified" educational expenses. The qualified expenses include tuition, room and board, fees, books, supplies and equipment. It doesn't include student loans. They aren't considered a qualified expense. What's more, the qualified expenses are to be paid out of the 529 plan when the bill is incurred. Delay is not an option, either.

So, with your delay-until-after-graduation strategy, you would lose the tax perk on any accumulated earnings withdrawn from the 529 and pay a 10 percent penalty. Still, congratulations on having set aside money for college. The savings will reduce the amount of money borrowed.

About the author

Chris Farrell is the economics editor of Marketplace Money.

Comments

I agree to American Public Media's Terms and Conditions.
With Generous Support From...