college

Life insurance or 529 for college savings?

Books stacked with money inside
Highlights
  • Tax-free 529 distributions must be for "qualified education expenses."
  • Money in a cash value policy won't reduce your financial aid.
  • Life insurance policies have higher administrative and advisory costs.

Where you store your child's college savings could impact his or her ability to attend college almost as much as grades and standardized test scores. Section 529 plans -- the college savings vehicle preferred by many families and financial advisers -- offer federal and sometimes state tax benefits, and subtract far less from a student's financial aid package than money stored in a checking or savings account. But having a robust 529 college savings plan could hurt the student's chances at tapping other sources of financial aid, which has parents starting to examine other options, such as cash value life insurance policies. These policies, for example, don't offer state tax incentives but have fewer restrictions on distributions and offer a place for families to shelter funds from the federal financial aid methodology.

In the battle between 529 college savings plans versus permanent life insurance, here's how both fare.

Round 1: flexibility

According to the Internal Revenue Service, money in a 529 college savings plan can only be used for "qualified education expenses" including tuition, fees, books, and room and board at an accredited U.S. school. Should your child opt out of college, choose a foreign or unaccredited school or receive a full scholarship, you can transfer 529 funds to another beneficiary or pull the funds out and pay income tax on the withdrawal. You may also have to back taxes if you've taken state tax deductions over the years as well as a 10 percent penalty on earnings.

"With life insurance, it doesn't matter how you use the cash," says Jim Van Meter, founder and president of The College Planning and Funding Advisor in Reno, Nev. A student can use life insurance savings for college, a down payment on a house, to start a business or for retirement, he says.

Round 2: risk

Section 529 college savings plans fluctuate with the market. Whole and universal insurance policies frequently provide guaranteed returns if time is on your side, says Myron Feinberg, a Certified Financial Planner and founder of the College Aid Specialist in Commack, N.Y.

"In the first two years of a life insurance policy you're getting a minimal of rate of return because (insurance providers) are pulling out the costs," says Feinberg. "After 10 or 12 years, you will see a rate of return of 4 (percent) to 5 percent."

Guaranteed returns can cap your earnings. Should the market generate returns above the fixed rate on your policy, life insurance holders may not earn any additional cash -- whether you can depends on your insurance provider and policy.

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"The thing about a permanent life insurance policy is that you want to put as much money in as the government will allow you," says Jim Kuhner, owner and certified college planning specialist at College Selection Strategy in Keller, Texas.

Unlike 529 plans, some life insurance policies use a tiered system when doling out returns. The more you invest, the better your return rate. To maximize earnings, Kuhner advises families to purchase a policy with a low death benefit and to contribute the maximum allowance.

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