A college education may be the key to a better job for most Americans, but saving for college is daunting. College comes at an alarmingly high cost these days. Clearly, most families need a long-term savings plan if they hope to help their children avoid a mountain of student loan debt. For nearly three in 10 households, the method of choice is a tax-advantaged 529 plan. But permanent life insurance, which has a tax-deferred savings component, is a possibility too, as many insurance agents will eagerly tell you. Here's a look at both options for establishing college funds for kids.
- 529 plans and permanent life insurance are two ways to create college funds for kids; both have pros and cons.
- A 529 plan allows tax-deferred saving with tax-free withdrawals. The downside is that it counts as an asset when you apply for financial aid, while a life insurance policy doesn't.
- Permanent life insurance includes a savings feature that can be used for college expenses; the downside is costly 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. Through a 529 savings plan, you can invest in a selection of mutual funds, and your earnings will grow tax-deferred. As long as you use the money for what the IRS considers qualified education-related expenses, your withdrawals will be tax-free.
Most states also offer a state 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 away money for college, it’s not the only path that offers tax benefits. Another option is to take out 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, a portion goes toward the death benefit and another portion is diverted to a separate cash-value account.
From an investment perspective, whole life insurance is generally the safest kind of permanent life insurance. The issuer credits your account by a guaranteed amount, although it may pay more if the investments perform well. Most policyholders can expect a return of anywhere from 3% to 6% after the first several years. Meanwhile, the money in the cash-value account grows tax-deferred, much like a 529 plan.
Other types of permanent life coverage, such as variable life insurance, give policyholders a degree of control over their investment. In this case, you select the sub-accounts—essentially mutual funds—that you want to be attached to your policy, and your account’s annual return is pegged to the performance of these underlying investments. The potential reward is greater, but there’s a risk that your balance could fall in a given year if the market takes a plunge.
When it’s time for your child to start college, you can take out a loan against your cash balance. The insurer will reduce your death benefit if you don’t pay back the loan, but that’s not necessarily a drawback if you intended the policy primarily as a college savings plan all along.
Pros of Using Life Insurance for College
When contrasted with a 529 plan, life insurance has a couple of benefits. One is flexibility. Suppose your child decides against going to college. Any earnings in your 529 account, but not your contributions, will be subject to ordinary income tax rates and usually a 10% tax penalty if you decide to withdraw them. There are some plans that allow the beneficiary, who is generally in a lower tax bracket, to withdraw the funds. But it’s still a significant tax hit that life insurance owners don’t have to face. You also have the option of naming another relative as the 529's beneficiary.
The other advantage of life insurance is that it’s not included in financial aid calculations. By contrast, the money in a 529 plan is considered a parental asset, and up to 5.64% of parental assets are counted in the applicant’s Expected Family Contribution for each year of college.
A 529 plan that you open directly with the plan's sponsor can be considerably less expensive than one you buy through a broker or other financial advisor.
Cons of Using Life Insurance for College
Permanent life insurance also has some less attractive features, such as upfront and recurring fees that can make stock and bond fund fees look like a steal. For example, 50% or more of your first-year premiums will typically go to pay the insurance representative’s commission. As a result, you’re starting in a pretty big hole.
It can take 10 years or more for your cash value to surpass what you have paid in premiums. So unless you buy a policy before your kids are in kindergarten, it’s hard to make a case for life insurance as a way to build up your assets in time for paying tuition bills.
On top of that, heavy annual expenses will continue to weigh down your earnings. Most permanent life policies charge upwards of 2% per year in administrative and investment costs.
In comparison, the average fund in a 529 account that is sold directly, rather than through a financial advisor, had fees of 0.35% in 2020, according to a May 2021 report by the research firm Morningstar. Advisor-sold funds were considerably more expensive than directly sold ones, averaging over 0.89%.
What Are the Pros and Cons of the 529 plan?
The tax breaks are the 529's main benefit. You can invest in a range of mutual funds, and your earnings will grow tax-deferred. As long as you use the money for what the IRS considers qualified education-related expenses, your withdrawals will be tax-free. The downside is that the savings count as an asset when you apply for financial aid, possibly reducing your eligibility for certain kinds of aid. A life insurance policy doesn't count as an asset.
What Are the Benefits and Drawbacks of Using Permanent Life Insurance for College?
A big bonus is that you can take out a loan against your cash balance for college. The insurer will reduce your death benefit if you don’t pay back the loan, but that’s not necessarily a drawback if you intended the policy primarily as a college savings plan all along. Fees are the big drawback. For example, 50% or more of your first-year premiums will typically go to pay the insurance representative’s commission. As a result, you’re starting in a pretty big hole. It can take 10 years or more for your cash value to surpass what you have paid in premiums. So, unless you buy a policy before your kids are in kindergarten, it’s hard to make a case for life insurance as a way to build up your assets in time for paying tuition bills.
What Are Other College Savings Plans?
A Coverdell Education Savings Account (ESA) can be set up at a bank or brokerage firm to help pay the qualified education expenses of your child or grandchild. Custodial savings accounts like Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts allow you to put money and/or assets in trust for a minor child or grandchild.
The Bottom Line
Even though you may in effect have to forfeit a small chunk of your account because of financial aid rules, you’re likely to come out ahead by using a 529 plan because of its lower expenses.
Should you still decide to purchase a permanent policy instead of a 529 plan, then it's all the more important to carefully research any firms you're considering to ensure you receive the best life insurance policy possible.