A 529 plan is a savings plan sponsored by many states that allow parents, grandparents and others to set aside money on a tax free-basis to help a student attend college. As with any savings plan, the money can be deducted at any time and used to pay for anything. However, deducting the money to pay for college loans will incur a tax penalty.
Approved 529 Withdrawals
Tax-free withdrawals from 529 plans must pay for expenses incurred during the same year the withdrawal is made, which is rarely the case for student loans. In addition, a withdrawal must be used to pay for a "qualified higher education expense," such as tuition, books, room and board or fees associated with attending college. The Internal Revenue Service does not consider student loans to be a qualified expense.
Funds set aside in a 529 account can be withdrawn and used to pay off student loans, but because those loans are not a qualified expense, the amount of earnings withdrawn will be subject to federal income tax as well as a federal tax penalty valued at 10 percent of the withdrawal. In addition, money withdrawn from a 529 to pay for college loans or another unqualified expense may be subject to other state or local tax penalties.