A college education may be the key to a better job for most Americans, but it comes at an alarmingly high cost these days. The average bill for tuition and fees was $34,740 at private colleges in the 2017–2018 school year, according to the College Board. The average was $9,970 for state residents at public colleges and $25,620 for out-of-state students at public universities.
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 the tax-advantaged 529 plan. But investing in permanent life insurance, which has a tax-deferred savings component, is an option too. Here's a look at both options.
- A 529 is the granddaddy of college savings plans, allowing families to invest in a plan similar to an IRA in which earnings grow tax-free until withdrawn, provided the money that is withdrawn is used for educational purposes.
- Whole life insurances policies include both a death benefit and a cash-value portion that a family could take a loan out on to cover college expenses; the principal portion of the loans are usually tax-free.
- The main downside of a 529 plan is that it counts as an asset when you're applying for financial aid, reducing whatever help you might get, while the money in your life insurance policy does not.
- The main downside of using life insurance money is that insurance policies tack on various yearly and one-time fees; additionally, if you don't pay back the loan you take out, it will reduce your policy's death benefit.
- If you start saving early and are risk-averse, whole life insurance policies might be best, but the simplicity and much lower fees associated with a 529 arguably make these plans a better option for most families.
How the 529 Plan Works
State-run 529 accounts are similar to a Roth 401(k) or IRA, but they're aimed at college rather than retirement savings. You can invest in a basket of mutual funds and the earnings grow tax-free until you make a withdrawal. As long as you use the money for certain education-related expenses, you will not be charged capital gains tax on the funds you remove.
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 permanent life insurance, which, unlike term coverage, has a tax-deferred savings component. If given time for the plan’s cash-value segment to grow, parents can draw on these funds tax-free to pay tuition and related expenses.
Investing in Life Insurance
Here’s how permanent life insurance works as a college savings tactic: For every dollar you pay in premiums, a portion goes towards 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 version. 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.
Other types of 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 son or daughter 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 for those who intended the policy primarily as a college savings plan.
In most cases, the principal portions of these loans are tax-free. (For more, see Cut Your Tax Bill With Permanent Life Insurance.)
Pros of Using Life Insurance
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. There are some plans that allow the beneficiary, who is usually 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.
The other big advantage of insurance is that it’s not included in financial aid calculations. Conversely, money in a 529 account counts as a parental asset, whether the parent or child is the owner. And up to 5.64% of these assets are included in the applicant’s Expected Family Contribution.
You can shop around for other states’ 529 plans in order to find one with good investment options and low fees; in most cases, you can use the funds to pay for college somewhere else.
Cons of Using Life Insurance
But there are less attractive features of permanent life insurance. There are 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 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 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.
On top of that, heavy annual expenses continue to weigh down your earnings. Most permanent life policies charge upwards of 2% per year in administrative and investment costs.
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 the 529 because of the lower expenses.