Get a Discount Off Student Loans if You Can

Disclaimer: this is not for everyone, and is a great example of how adding complexity sometimes goes along with “tax optimization.” If you get a kick out of that sort of thing and have student loans, read on!

If you have student loans, and also live in a state that offers a tax benefit for 529 plans, you may be able to get a bit of a discount off paying down your loans. In late 2019 a new piece of legislation became law, the SECURE Act, which allows people to take up to $10k out of a 529 account as a “qualified distribution” to pay off student loans. A few quick things to recap 529 accounts:

  • A 529 account is a type of tax-advantaged account to help people save for educational expenses, like college. You put money in the account and can invest it in things like mutual funds. The money grows tax-free, like a Roth IRA.
  • When you withdraw money to pay for “qualified” educational expenses, you pay no tax on the money withdrawn, not on the original contributions you made or on any investment earnings.
  • If you withdraw for a non-qualified educational expense, you pay income taxes on the investment earnings as well as a 10% penalty (so don’t do that!)

In many states, including in New York where I live, when you contribute to a 529 plan, you can take a tax deduction. This deduction is where the action is for saving on student loans, so hang with me here. This means your taxable income at the state level is reduced by the amount of your 529 contribution, so it’s as if the state is subsidizing your contribution at your state income tax rate.

  • In New York, a single person (tax filing status) can deduct up to $5k a year. Married filing jointly people can deduct up to $10k a year.
  • Let’s say I’m single, living in NYC, and my federal taxable income is $60k. My combined state and city marginal income tax rate is 10%. If I contribute $1,000 to a 529 plan, my state and city income taxes would go down by $100 (=10% * 1,000), or if I contributed $5k, I’d save $500 off my city and state income taxes.

Tax deductions work like this:

So, let’s say you aren’t saving for college, but are working to pay off loans you took out previously. Now that you can use money in a 529 to pay off loans, you can contribute money to a 529, get the state tax deduction, and take money out of the 529 to pay off your student loans.

Is it worth the bother? It depends on (1) if you get a state tax deduction (in NY it is not yet determined as of the date of this article), (2) the dollar value of your deduction, i.e., how high are tax rates in your state (and city if you pay city income taxes) and how much can you deduct, (3) if there are fees for opening/maintaining a 529 account (NY’s costs $1.34/year for every $1,000 invested) and (4) if you’re willing to jump through some hoops and spend time to get this benefit.

Personally, I would be willing to put in at least a few hours of work for something like a $500 benefit (if it took me under 5 hours that would be a pretty sweet wage at more than $100/hour!)

Do note that there is no double dipping! If you pay student loan interest with money distributed from a 529 plan, that interest is not eligible for the student loan interest deduction. Is one better than the other? The student loan interest deduction will reduce your income subject to both federal and state+city taxes. The 529 deduction will only reduce your income subject to state+city taxes (no federal tax break). So I’d recommend this move for extra principal payments on student loans. Pile up some savings, move them into a 529, and crush your student loans into oblivion!