Saving for College: Life Insurance or 529?

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A college education can be the key to a better job for most Americans, but saving for college is intimidating. College comes at an alarming cost these days. Obviously, most families need a long-term savings plan if they are to help their children avoid a mountain of student debt. For nearly three in ten households, the method of choice is a tax-efficient 529 plan. But permanent life insurance, which has a tax-deferred savings component, is also a possibility, as many insurance agents will eagerly tell you. Here is an overview of the two options for establishing college funds for children.

Key points to remember

  • 529 plans and permanent life insurance are two ways to create college funds for children; both have advantages and disadvantages.
  • A 529 plan allows for tax-deferred savings with tax-free withdrawals. The downside is that it counts as an asset when applying for financial assistance, unlike a life insurance policy.
  • Permanent life insurance includes a savings feature that can be used for college expenses; the downside is expensive fees.

How 529 Plans Work

State-run 529 plans are similar to a Roth 401 (k) or Roth IRA, but are intended for education rather than retirement savings. With a 529 Savings Plan, you can invest in a selection of mutual funds and your income will grow tax free. As long as you use the money for what the IRS considers qualifying education expenses, your withdrawals will be tax-free.

Most states also offer a tax deduction or credit for your contributions to their plans, which only adds to their appeal. Unfortunately, there is no federal deduction or credit for your contributions.

While the 529 is in some ways the gold standard when it comes to putting money aside for college, it’s not the only path that offers tax benefits. Another option is to purchase a permanent life insurance policy which, unlike term life coverage, has a tax-deferred savings component.

How permanent life insurance works

Here’s how permanent life insurance works as a college savings vehicle: for every dollar you pay in premiums, part goes towards the death benefit and another part goes to a cash value account. separate.

From an investment perspective, whole life insurance is generally the safest type of permanent life insurance. The issuer credits your account with a guaranteed amount, although it may pay more if the investments are going well. Most policyholders can expect a return of 3% to 6% after the first few years. Meanwhile, the money in the cash value account increases tax-deferred, much like a 529 plan.

Other types of permanent life coverage, such as variable life insurance, give policyholders some control over their investment. In this case, you select the sub-accounts, mostly mutual funds, that you want to tie into your contract, and the annual return on your account is tied to the return on those underlying investments. The potential reward is greater, but there is a risk that your balance will drop in any given year if the market plunges.

When it’s time for your son or daughter to go to college, you can take out a loan from your cash balance. The insurer will reduce your death benefit if you don’t pay off the loan, but that’s not necessarily a disadvantage if you’ve designed the policy primarily as an education savings plan from the start.

Benefits of life insurance for college

As opposed to a 529 plan, life insurance has a few advantages. One is flexibility. Suppose your child decides not to go to college. All income in your 529 account, but not your contributions, will be subject to regular tax rates and generally a 10% penalty tax if you choose to withdraw it. Some plans allow the beneficiary, who is usually in a lower tax bracket, to withdraw the funds. But it’s still a big tax impact that life insurance owners don’t have to contend with. You also have the option of designating another parent as the beneficiary of 529.

The other advantage of life insurance is that it is not taken into account in the calculation of financial aid. In contrast, money from a 529 plan is considered a parental asset, and up to 5.64% of parental assets count towards the candidate’s expected family contribution for each year of college.

A 529 plan that you open directly with the plan sponsor can be considerably cheaper than a plan that you buy through a broker or other financial advisor.

Disadvantages of Using Life Insurance for College

Permanent life insurance also has less attractive features, such as upfront and recurring charges that can make equity and bond fund fees look like a bargain. For example, 50% or more of your first year premiums will generally be used to pay the insurance representative’s commission. As a result, you start in a pretty big hole.

It may take 10 years or more for your cash value to exceed what you paid in premiums. So, unless you buy a policy before your kids are in kindergarten, it’s hard to argue for life insurance as a way to build your assets in time to pay for school fees.

In addition, heavy annual expenses will continue to weigh on your income. Most permanent life insurance policies charge up to 2% per year in administrative and investment costs.

By comparison, the average fund for a 529 account sold directly, rather than through a financial advisor, had a fee of 0.35% in 2020, according to a May 2021 report by research firm Morningstar. Funds sold by advisors were considerably more expensive than those sold directly, averaging over 0.89%.

What are the pros and cons of the 529 plan?

The main benefit of the 529 is tax benefits. You can invest in a variety of mutual funds and your income will grow tax free. As long as you use the money for what the IRS considers qualifying education expenses, your withdrawals will be tax-free. The downside is that savings count as an asset when applying for financial assistance, which can reduce your eligibility for certain types of assistance. A life insurance policy does not count as an asset.

What Are the Pros and Cons of Permanent Life Insurance for College?

A big bonus is that you can take out a loan against your college cash balance. The insurer will reduce your death benefit if you don’t pay off the loan, but that’s not necessarily a disadvantage if you’ve designed the policy primarily as an education savings plan from the start. The big downside is the fees. For example, 50% or more of your first year premiums will generally be used to pay the insurance representative’s commission. As a result, you start in a pretty big hole. It may take 10 years or more for your cash value to exceed what you paid in premiums. So, unless you buy a policy before your kids are in kindergarten, it’s hard to argue for life insurance as a way to build your assets in time to pay for school fees.

What are the other education savings plans?

The bottom line

While you might have to lose a small portion of your account due to financial aid rules, you’ll likely get a head start using a 529 plan due to its lower spending.

If you still decide to buy a permanent policy instead of a 529 plan, it is all the more important to research all the companies you are considering carefully to ensure that you receive the best possible life insurance policy.


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