What Can You Do if Your 529 Expectations Change?

Question: I've been putting money in a 529 college-savings account for my son ever since he was born. But now that he's getting older, I was wondering: What are my options if he gets a scholarship or doesn't go to college?

Answer: Your first instinct might be to take distributions immediately. After all, if you've been saving for a while, there's a good chance you're talking about a significant amount of money. For the 2010-11 academic year, the average 529 account balance was around $17,000, according to The College Savings Plans Network. But although cashing out might be tempting, think twice. You'll pay federal and state income taxes on earnings from the unused portion of the account, plus a 10% penalty (unless the beneficiary dies, becomes disabled, or receives a scholarship). Furthermore, if you've claimed state income tax deductions for contributions to a 529 plan, you might owe back taxes.

Another reason to wait: After a year or two in the working world, your son might just come back to you, begging to use that 529 after all.

All in the Family
But even if he doesn't, the good news is that if you choose to keep the money in a 529, you have many options. Perhaps the easiest is to simply name a new beneficiary. Assets in the account remain the same, and the new beneficiary gets to use the money as long as it's for qualifying college-related expenses. Or you can transfer the funds to the new beneficiary's existing 529 plan. Just remember that you must do so within 60 days after the date of distribution or you might get stuck paying taxes and a penalty on the amount. Also bear in mind that the new beneficiary must be a family member of the old beneficiary, not of the person who opened the account. So if you open a 529 for your best friend's daughter and she no longer needs it, the funds must be transferred within your friend's family, not yours.

Fortunately, the list of family members who you can name as beneficiaries is rather broad. Recipients can be related to the original beneficiary in a variety of ways:

• sibling or step-sibling
• first cousin
• child
• niece or nephew
• parent or step-parent
• grandchild
• aunt or uncle
• son- or daughter-in-law
• brother- or sister-in-law
• mother- or father-in-law

It's important to remember that a 529 plan is controlled by the person who opens the account, not the beneficiary. So it's up to you to decide what happens to any unused funds.

How Other Plan Types Treat Unused Funds
Another popular college-savings vehicle, the Coverdell Education Savings Account, also allows transfers of unused assets to a beneficiary's family members. But one key advantage 529 savings plans have over Coverdells is that typically there is no age limit on who may use the assets, whereas Coverdells generally must be started before the beneficiary reaches age 18 and any funds remaining when he or she reaches age 30 must be cashed out. (For a fuller discussion of the advantages and disadvantages of various college-savings vehicles, read Christine Benz's recent article on the topic.) This makes the 529 savings plan a more flexible option in case you have a family member who returns to college after his or her 20s.

Unused funds in prepaid tuition plans--a different type of 529 in which account holders essentially buy credits toward future tuition payments at today's prices--are also transferrable, but age restrictions may apply. Your best bet is to check with the prepaid tuition plan you are considering before opening an account.

Still another educational savings account type, the UGMA/UTMA, has a major drawback in terms of transferability: The assets technically belong to the beneficiary, who by law assumes control of them when he or she turns 18 or 21 (depending on the state). That means a student who decides not to go to college can take the money and do as he or she pleases with it.

Other options, such as keeping money in a taxable account or using money from a Roth IRA, offer a high degree of flexibility if your child decides college isn't right for him or her. For example, unused assets that were originally earmarked for college can be plowed into your retirement plan. That's appealing, but bear in mind that qualified withdrawals from a 529 or Coverdell would be tax-free; you wouldn't have that benefit with investment vehicles that aren't geared explicitly for college.