How Not to Use Life Insurance to Pay for College

Here’s a "secret solution" to all your college funding worries: Use life insurance to pay for college by hiding your assets to lower your expected family contribution…and then spend more on college. Say what?!

Like anything else, there’s a right way and a wrong way to use life insurance to pay for college. Let’s go over the wrong way now.

Life insurance. Everyone needs it, right? Sure. Most of my clients are woefully underinsured for the financial obligations and needs that they have. But getting life insurance for the wrong reasons is as bad as not having any in the first place. More and more people are hearing the siren call of "college planners" who woo prospects with fantastical tales of how to get more aid and lower their costs. How? Well, easy, you use life insurance to hide assets. What they don't tell them is they will likely spend more on college.

With the average cost of a state school with room and board at about $30,000 per year and a private school—not even an Ivy—above $50,000, you can’t blame parents for looking for innovative ways to lower the cost of college. For related reading, see: How to Find a Tuition-Free College Education.)

And life insurance and some annuities are the types of assets which are not reported on the FAFSA, the college financial aid form used by the vast majority of schools. For those trying to get into Ivies or certain private and state schools, students will use the CSS Profile form. But these schools may or may not ask about life insurance cash value. (For more from this author, see: Why Wealthy Families Should Complete the FAFSA.)

Pay $40,000 Extra for a College Degree

So what’s a parent to do? As a college financial planner, I’m happy when parents think ahead and bring me on board. Unfortunately, many parents go to other "college planning" places that are covers for life insurance producers. Like I said, there’s nothing wrong with life insurance. There’s a need and they can fill it. But sometimes a good thing can go too far. 

Case in point: A colleague’s client comes into the office excited with a recommendation from a "college planning service" to use life insurance to remove assets from financial aid consideration. Since the client has an adjusted gross income over $200,000 per year, they are likely not to qualify for need-based financial aid beyond federal unsubsidized student loans.

But these folks have been diligent savers. They have accumulated $264,000 in 529 savings plans. Now they’re being told to cash out the 529 plan, pay the taxes (estimated at over $40,000) and use the proceeds to fund a cash-value life insurance policy. With an initial contribution of $230,000 to fund the insurance policy, they’ll immediately be able to make this asset "invisible" during financial aid consideration.

Yep, in part that’s true. That mainly applies to FAFSA schools that don’t look at life insurance cash value. Some CSS Profile schools, too. But the private schools do reserve the right to ask about other assets—including cash-value life insurance.

How do you think that conversation will go over?

Financial Aid Officer to Parent: So, do you have any life insurance with cash value?
Parent to Financial Aid Officer – hesitantly: Why? It’s not an asset.
Financial Aid Officer to Parent: It’s our policy to ask so we have a more complete picture of each family’s resources.  And we see on your tax return that you cashed out your 529 Plan. So where did that money go?
Parent to Financial Aid Officer: But, but…
Parent to Self: What did I pay for? *&#!&@ college planner!

These folks give those who know what it means to do holistic financial planning a bad name.

Never does this "planner" mention that the parent will be required to pay taxes on the 529 plan distributions and a penalty for using the funds for something other than qualified education expenses. There is no discussion of how tying these funds up in an insurance policy may put the family in a cash flow bind so the policyholder has to "borrow" the funds from the policy. Nowhere is there any mention that by using a lump sum to fund a cash value policy that they’ve created a modified endowment contract (MEC) that makes this no longer a life insurance policy but a nonqualified annuity subject to income taxes on withdrawals. (For those interested, I’ve written about the myths of another MEC, the Gerber College Plan.)

So pay taxes now and pay taxes later. Sounds like such a great deal…for the college planner/life insurance agent and his firm since they will walk away with a commission of $10,000 to $20,000 while Mom and Dad pay $40,000 in taxes on the 529 distribution plus what they pay on withdrawals from the MEC later.

Late-Stage College Planning

For clients who come to me with kids who are juniors or seniors in high school, life insurance is not going to help them. It will help the insurance salesperson. The financial aid formulas are mostly driven by income of the parent and the child. If there are legitimate ways to reduce income, then the client may qualify for needs-based aid. This is mostly possible for those who are self-employed, have a Schedule C side business or are investment property owners. (For related reading from this author, see: Is It Ever Too Late to Start a 529 Plan for College?)

Admittedly, most people are under-insured and there is an argument that the family may need insurance to cover the cost of education or loans incurred. But when a child is about to graduate from high school, the best option is going to be term insurance. If the college planner was talking to parents with infants, then there’s arguably more time for cash-value life insurance to make sense.

But moving money from a 529 account to incur tax costs to fund a MEC that also has tax costs is courting a malpractice suit, in my opinion.

If the student were looking at a school using the CSS Profile which counts home equity, then you could possibly make the argument that using home equity to fund the insurance policy could shelter some assets from being assessed. But most schools using the CSS Profile cap how much home equity they consider, so the value of this is very limited. 

By the way, merit aid is based on merit, not the financial profile of the student. And many Ivy League schools (which use the CSS Profile) don’t even give merit aid. So, the college planner’s advice here is dubious at best.

(For more from this author, see: How to Pay for College Without Lots of Debt.)