One of the “drawbacks” with my personal finance hobby is discovering new ways that I’ve financially messed up in the past. This week I discovered an HSA trick that I wish I had known when I paid off the remainder of my student loans in December 2019. My ignorance cost me $401.
Terminating My Student Loans
Like many college students, I graduated with student loans. Following graduate school, I consolidated my loans along with my wife’s loans at a 3.125% rate. By enabling autopay, I got the rate reduced to 2.875%, and after having 36 months of on-time payments (kinda hard not to with auto pay turned on), the rate dropped another 1%. My final rate was a super low 1.875%. The student loan interest deduction reduced that even further.
Here’s a graph of the principal balance alongside monthly interest payments. You can see the slight bend in the graph at the end of 2007 when the lower 1.875% rate kicked in:
When we bought our first house following graduate school, it was the halcyon days before the 2008 meltdown, a.k.a. the Time of Shedding and Cold Rocks. Our loan setup involved a variable rate HELOC that had a teaser 6% for the first 36 months that then went variable with a rate that got as high as 10% before we refinanced out of it. Needless to say, we poured every extra bit into paying back the HELOC while only paying the minimum on the student loans.
Fast forward to 2019 and a total student loan balance of $6,975. So far, we’ve paid a total of $7,589 of interest over the life of the loan, $5,531 of which was tax deductible, saving us $1,346 of tax. We no longer qualified for the student loan deduction on our taxes and we also wanted to simplify our financial picture. It probably made financial sense to drag out the loan with its sweet, low interest rate but I decided instead to finish paying them off. In December of 2019, we wrote the last check to the loan servicer.
529s and Student Loan Debt
Oops! What I didn’t know at the time was that at the same time I was making this decision, the Secure Act of 2019 was signed, enabling paying down student loans using 529 money. There were some restrictions, such as being capped to only $10k per beneficiary and not being able to use the student loan interest deduction at the same time, but neither of these were a problem for us.
The question is, what should I have done instead, assuming I still wanted to pay off the loans?
- First, Open a 529 account with me as the beneficiary and contribute $6,975, boosting my Virginia state income tax refund by $401
- Either I would have needed to either spread this across 2019 and 2020, or invest in two different options to maximize my Virginia state income tax deduction.
- Given that I needed to withdraw the money by the end of 2020, I probably would have chosen safer options, such as the Inflation-Protected Securities or the FDIC-Insured options.
- Second, wait until January 2020 to pay off the loan
- Third, withdraw $6,975 from the 529 anytime during 2020, probably waiting until late December to maximize my compounding
- Fourth, if funds remained in the 529, change the beneficiary to my daughter for her use.
Not taking these steps ended up costing us $401 of state income tax savings.
Hack: 529 + Student Loan
First, a caveat. Student loan debt isn’t like other debt. It’s not easily discharged through bankruptcy like other debts can. Taking on these loans is serious business and messing things up can have long term repercussions.
My daughter hasn’t taken out any loans to pay for her schooling. Now I’m starting to think maybe she should, even though technically she hasn’t needed them yet. By taking out $10k of loans and passing the money through a 529 account, she would score the state income tax deduction, even if she then paid off the loans immediately. A side benefit is a likely boost to her credit score which could be helpful later.
Taking out a student loan isn’t free. According to StudentAid.gov, loans originated in 2021 have a 1.057% origination fee, or $106 per $10k of loan. That brings the potential $575 Virginia state income tax benefit down to $469.
In addition, she only qualifies for unsubsidized loans with an interest rate of 2.75%. If she decides to pay the loans off immediately, she maximizes the benefit. If she holds on to the money and doesn’t pay the loans off immediately, the interest will slowly eat into the arbitrage spread, finally cancelling it out 20 months later.
Given that most of the 529 options have easily beaten the 2.75%, maybe it makes sense to keep the money in the 529 until the end of her school, keeping her options open.
The theoretical max is $10k, but in reality, as a sophomore she is limited to $6,500 of loans this year. She’ll just need to spread things out if she goes this route.
If you still have student loans you are paying off and you live in a state that gives state tax benefits for 529 contributions, you really should consider passing the money through a 529 account to get the state income tax deduction. If you’re the parent of a student in a state that gives a tax benefit for 529 contributions, you might consider taking out loans even if you don’t think you’ll need them.
Anything else I should be considering? I’d love to hear in the comments.