Life insurance or 529 for college savings?

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With the annual cost of a college tuition averaging more than $34K for the 2018-19 school year, parents are increasingly realizing the value in establishing a financial savings vehicle for their children early. One common way to do this is through a 529 college savings plan. 529 plans are available in all 50 states, and are meant specifically to provide a tax-deferred way to save for higher education or — since 2017 — for K-12 as well.

But is this the best way to save for college? 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. For example, using life insurance to pay for college, doesn’t offer state tax incentives, but has fewer restrictions on distributions and offers a place for families to shelter funds from the federal financial aid methodology.

Life insurance vs 529 plans

Since every person’s situation is unique, no one investment vehicle is right in every situation. For some families, having the flexibility to move funds around, change beneficiaries or dedicate the investment to something other than education is the top priority.

For other families, a low-risk option is something they may be more comfortable with, and they’re happy to give up potential spikes in income in favor of solid savings that won’t lose money if the economy tanks.

Still others may care more about the inherent costs of their savings accounts, or the way their savings will impact financial aid. Let’s take a look at these factors and see where each investment option shines.

Flexibility

According to the IRS, a 529 account can only be used for qualified educational expenses. This includes tuition, lab and other fees, books and room and board at an accredited U.S. school or an apprenticeship program.

If you withdraw money from the account and use it for any other purpose, you will pay income tax on it — possibly back taxes if you’ve taken state tax deductions — and a 10% penalty on the earnings. If your child decides not to attend college or earns a full scholarship, you can switch your account to benefit another family member, but unless the child it is intended for dies or is disabled, there will be penalties for other uses.

Income from life insurance, on the other hand, can be used for any purpose — college, the down payment on a house, to start a business. Use of this money is at your discretion as well. “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.

Drawing on life insurance for college savings gives you more flexibility and may be the better investment vehicle if you are not sure that your child will be able to use it — or will need to use it.

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 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.” This factor benefits those who begin saving as early as their child’s birth, rather than when he or she is in their teens, because life insurance policies have little cash value in their first decade.

But 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 is dependent on your insurance provider and policy.

Depending on the state in which you’re purchasing your 529 policy, you may have options on where the money will be invested. Many people choose fairly safe mutual funds. But if you have a high tolerance for risk, you could potentially direct your money toward more aggressive investments — something you may not be able to do with your life insurance policy.

“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.

Financial aid

One of the major advantages to using a cash value insurance policy for college savings is that money in an insurance plan won’t reduce your financial aid. Money in a 529 college savings plan, when owned by a custodial parent, can subtract up to 5.6 cents in aid for every dollar stored in the account, but cash value policies are sheltered from the federal financial aid formula, according to the Department of Education.

“If families take money out of a life insurance policy for college, they need to do that as a loan,” says Jim Van Meter, founder and president of The College Planning and Funding Advisor in Reno, Nevada.

Van Meter also says that taking a loan against a life insurance policy won’t count against your financial aid but will reduce your death benefit. Cashing a policy out entirely will count as income and can reduce your aid package by up to 47 percent and could incur surrender charges.

If you are struggling financially, you may be protected. Families with assets that fall under a certain amount (the amount is determined by the age of the older parent) may take that money as an asset protection allowance, which does not impact financial aid. For the 2020-21 school year, that maximum is $9,400.

Cost

Section 529 plan managers may charge an enrollment/application fee, annual account maintenance fees, ongoing program management fees and ongoing asset management fees. These administrative and advisory costs can range from 0.25 percent to 1.85 percent but charges on cash value insurance policies can easily top 2 percent, says Kuhner. To reduce the costs, Kuhner advises families to insure the student rather than listing him or her as the beneficiary.

“The mortality charges are going to be much less,” he says, adding that policies for young, healthy kids are substantially cheaper than those for adults.

Besides paying higher administrative and advisory costs, Peter Laurenzo, a Certified Financial Planner and president of College Aid Planning Associates Inc. in Albany, N.Y., says parents saving for college in an insurance policy won’t get a state income tax deduction that many 529 holders receive.

“In a New York 529 plan, (families) get a state tax deduction up to $5,000 per parent,” he says. “That’s significant.”

However, not every state offers a 529 deduction and most that do only offer it to residents invested in that state’s plan.

Before enrolling in a life insurance or 529 plan, comparison shop and have a financial adviser crunch the numbers to see whether the no-risk returns of a life insurance plan outweigh the costs and lost tax deduction.

Which is a better investment to pay for college?

There’s no one right answer to this question. Every family has unique financial considerations to evaluate, and what works for one might end up being a financial drain on another. In addition, the fact that 529 plans are administered by each state means that there are different regulations and fees in play; you’ll want to do your homework to determine what works best for you.

In general, 529 plans are a good choice if you are looking for a way to shelter some income from taxes. Many 529 plans have tax advantages, so higher-income families may benefit.

529 plans are also an easy way for extended family or other relatives to help their loved ones manage college expenses. Contributions can be made periodically, although that is not required, making them a good choice if someone wishes to contribute occasionally and not on a specific schedule.

Alternatively, a whole life insurance policy offers an increased range of options for the holder, since it does not need to be used for educational expenses. There is no maximum contribution, as there is with 529 plans, and in addition to allowing for educational expenses, should include a death benefit unless it’s been maxed out for educational purposes. Life insurance is not considered an asset when determining financial aid, and therefore has no impact on it.

Frequently Asked Questions

What expenses can I pay for with my 529 savings account?

Generally, anything related to your education — including tuition, fees, books and supplies, on-campus room and board, some expenses if you live off-campus, computers and software. You may also use the account to pay for up to $10,000 of student loan debt.

Are all 529 plans alike?

No, there are two types. The most common is the educational savings plan, but there is also the option in some states to purchase prepaid tuition plans. These allow you to purchase credits at participating colleges and universities for future tuition at current prices.

If I take an education loan from my life insurance policy, are there long-term implications?

Yes; taking a loan from your policy will mean that the potential death benefit is likely to go down until you pay back the loan. Your insurer uses the policy as collateral for the loan, and they will add interest payments to the money that you’ve borrowed.