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Most parents worry about not having enough money in their 529 savings plans to pay for their kids' college expenses. But sometimes you can end up with more cash in these accounts than you need—if, say, a child doesn't go to college or attends a state school rather than a private university.
What then?
One option, of course, is to simply withdraw the cash. But if you do that, you will owe tax on the earnings, plus a penalty equal to 10% of the earnings portion of the withdrawal. Fortunately, there are plenty of other ways to use leftover 529 funds without incurring tax or penalties, says Matthew P. McCarthy, head of the education-savings group at Vanguard Group.
After all, avoiding tax is a key benefit of state-sponsored 529 plans, which are named for the section of the federal tax code that created them in 1996. The money, typically invested in mutual funds, grows tax-free, and withdrawals to pay for qualified higher-education expenses generally aren't subject to taxation.
Weighing the Options
If your intended beneficiary decides not to go to college, be aware that the money in a 529 plan can be used to pay for postsecondary vocational or technical training at schools eligible for financial-aid programs administered by the U.S. Department of Education. This includes schools that teach a variety of trades, such as automotive and aerospace maintenance, hairstyling and computer skills. A tool on the savingforcollege.com website, under "Tools & calculators," can tell you if a specific school is eligible.
If a child goes to college but graduates without wiping out a 529 account, you can always let the remaining money sit for possible graduate-school expenses.
You also can change the beneficiary of the account, so long as the new recipient is a family member. That might be a sibling or step-sibling of the original beneficiary, for example, or a first cousin. Alternatively, a parent who funded the account may want to take college courses on a part-time basis, or save the money for potential grandchildren. (In rare cases, there may be gift-tax or generation-skipping-tax consequences when you change beneficiaries.)
Say there is money left over in a 529 account because your child got a big scholarship that reduced his or her college costs. In that case, money withdrawn would be subject to tax on the earnings but the 10% penalty would be waived, as long as the withdrawal doesn't exceed the amount of the scholarship. The penalty on withdrawals also would be waived if the beneficiary dies or becomes disabled.
Unless you need the money in a 529 account for something else, there is no rush to make a decision. In most plans, you can leave funds in the account to grow tax-free indefinitely, as long as there is a living beneficiary. The account owner can change beneficiaries at any time.
However, if the money is likely to stay in the plan for longer than originally expected, review how it is invested. The key is to think about your time horizon and your tolerance for risk. "It's like any other investment," says Ron Rogé, a financial planner in Bohemia, N.Y. "If you think you'll need the money in under three years, look for something stable, like a short-term bond fund. If it's longer term, look for growth."
Know the Rules
Most of the more than $130 billion in 529 savings plans is invested in age-based portfolios, where the investment mix becomes more conservative as the beneficiary gets closer to college age. But most plans offer other options. Indiana's College Choice 529 plan, for instance, includes a U.S. Equity Index Portfolio, an International Portfolio and a Short-Term Bond Index Portfolio, among other options. Alaska has a Total Market Equity Index Portfolio, composed of one stock fund that aims to parallel the performance of the entire U.S. stock market, and an Equity Portfolio, composed of several stock mutual funds.
"There are 3,000 investment options among all the plans," says Joe Hurley, founder of savingforcollege.com. Almost all states have at least one plan, and an account owner usually can roll over assets from one plan to another—or change investment options—once every 12 months. Some plans charge a fee for rollovers.
Especially when investing for the long term, it is important to designate a successor owner for a 529 plan to ensure assets will be available to the beneficiary if the account owner dies. This can be done when the account is established, or later.
It pays to know the rules of the state plan in which you are invested. While two-thirds of states offer state income-tax deductions or credits for residents who invest in their plans, some, like New York, can move to recapture those benefits if the assets are moved to another state's plan.
A final thought: If there is no future beneficiary in sight, you may be able to mitigate the tax bite and the penalty by donating proceeds of the account to charity and taking a tax deduction—if you itemize deductions.
Ms. Jasen is a writer in New York. Email her at reports@wsj.com.
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