What to do with a 529 college savings plan if student debt is forgiven

One of the ways families can spend their 529 college savings plan is to pay down student loans.

But what if that debt is forgiven?

It has been widely reported that President Joe Biden is leaning toward a plan of canceling $10,000 per borrower. An official announcement is expected from the White House later this summer. That amount of relief would entirely clear the balance of about 33% of student loan borrowers, or close to 12 million people.

Currently, 529 account holders can use up to $10,000 to repay student loans for both the plan's main beneficiary and any siblings of the beneficiary. These state-sponsored investment plans allow parents to deposit money and then withdraw it tax-free, so long as the money is used for certain education expenses.

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Fortunately, families planning to use their 529 college savings for a student loan balance will be able to spend the money in a number of other ways, experts say.

"If you have leftover money in a 529 plan, you have several options," said higher education expert Mark Kantrowitz.

For one, if a parent has a remaining student loan balance after the forgiveness, they can make themselves the account beneficiary and use the funds for their debt. They should just keep in mind that the cap of $10,000 is a lifetime limit.

Usually changing the beneficiary is as simple as contacting your plan and filling out a form, Kantrowitz said.

You could also transfer the beneficiary to another relative whom you want to help with college costs, said Douglas Boneparth, a certified financial planner and president of Bone Fide Wealth in New York. 

"They can change the beneficiary to a pretty wide range of family members, including cousins and grandkids," Boneparth said.

You could also let the account sit and eventually use it for a grandchild, as there is no requirement to make a distribution, Kantrowitz said: "You could leave it as a legacy for future generations."

Parents might also make themselves the account beneficiary if they would like to pursue more education, Kantrowitz said. The accounts can be used for a wide range of continuing education, he said, including for professional certificates.

Under the plan rules, qualified higher education expenses generally include all tuition and fees, books, supplies, equipment, and room and board, if the student is enrolled at least half-time, Kantrowitz said.

You also have the option of withdrawing the money and taking the tax hit, Boneparth said. Those charges include income taxes and a 10% penalty on your earnings. But it may be worth it in some cases.

"After growing that money over 18 years or more, the tax-deferred growth can outweigh the tax and penalty of taking it out," Boneparth said.

Another plus is the tax rate you're dinged at can be based on the recipient of the distribution, Kantrowitz said, "so you can have the distribution paid to the student, who usually is in a much lower tax bracket."