Should You Use Life Insurance to Pay For College?
A recent article in U.S. News & World Report discussed the recent rise in the use of life insurance policies as college savings vehicles. With today’s high cost of college, many families are looking for creative ways to save more to pay for their children’s education, and life insurance is a unique vehicle with some useful benefits that can work to your advantage in this arena.
As this is a strategy that we often use with our college planning families, we are very familiar with the ins and outs of this practice, and we did want to point out some of the errors in this article.
While the authors did display a basic knowledge of cash-value life insurance, they missed the mark on a few very important aspects that we wanted to clarify.
First of all, based on the information in the article, it does not sound as if they are talking about the same type of life insurance policies that we use for our clients.
For example, at the start of the article, it mentions that parents may be surprised “when premiums continue to rise and erode cash accumulations.”
While the article doesn’t state specifically which type of life insurance it is referring to, this certainly sounds like Universal Life, which is not the type of policy that we recommend for college savings.
The Whole Life policies we use have level premiums that never increase, and when you are ready to stop contributing, you can take what is called a “Reduced Paid-Up” policy, meaning that no further premiums are due, but the policy remains in force, and you will still have access to the accumulated cash value. It is quite a different animal than a Universal Life policy.
Here are the 3 points that the article mentions as drawbacks to using whole life insurance policies to pay for college – and our responses and corrections:
1. Agent practices: Insurance agents typically generate their income via sales commissions. As a result, says Florida-based financial planner Carlos Dias Jr., “commissions frequently interfere with the way a life insurance policy is structured and most of the time the wrong product is used.” Dias says there are several life insurance companies that allow agents to take reduced commissions, which puts more money into the policy for its holder – but that’s rare.
The “rare” type of company (and policy) mentioned above is exactly what we use for our clients!
And this is exactly why we use them:
“If a life insurance policy had a minimum death benefit – versus higher death benefit – the policy has a higher cash accumulation because the cost of insurance is a lot lower,” says Dias. That’s because premium payments increase in proportion to the death benefit. If parents are purchasing a policy with the intent of saving for college, they are less concerned about having a high death benefit.
This is exactly the way we structure our policies to help our clients save for college costs. While it is true that the commissions may be lower up front, we find that we are able to better serve our clients’ needs, and thereby build stronger, more lasting and mutually beneficial client relationships, as well as gain more referral business over time, by putting our clients’ goals first.
2. High cost: Even when life insurance policies are structured with the maximum client benefit in mind, they still tend to be much more costly to maintain than other college savings vehicles, like state-sponsored, tax-advantaged 529 plans.
While there is a cost for a life insurance policy, you will be aware of this cost up front, as you will see the exact policy cash values you can expect for the life of the policy.
The same is not true for 529 plans, which also charge fees, but what is worse are the hidden and unpredictable “costs” of potentially losing your college savings during a market downturn! 529 plan values are typically at the mercy of the market performance of the investments within them.
Do you think that it is wise to house your college savings in a vehicle that is unpredictable and could lose money?
Unlike in a 529 plan, with a properly designed whole life policy, you will know exactly how much money you will have available to pay for college when you need it – and if the policy performs better than expected, you could even have more! Either way, there will be no nasty surprises, and once dividends and interest have been credited to your policy each year, you will never lose them to the whims of the market.
3. Withdrawal burdens: When parents purchase a life insurance policy to save for the child’s college expenses, there is an understanding that they will ultimately have to withdraw those funds. But this process often creates unexpected hassles.
“First, parents will have to pay income tax on the difference in amount if they withdraw more money than the premium they paid, as well as a potential 10 percent penalty if they are under age 59 1/2,” says Joyce Garner, an insurance broker with Zimmerman & Ray Associates in Roseville, California.
This should never happen if your policy is structured correctly – and if you are working with an advisor who knows what they are doing!
It is true that you would owe income tax if you withdraw more than you have put into the policy; However, this is why we work closely with our clients to make sure that they never go over this line. Once you withdraw as much as you have put into the policy, you can switch to taking loans, which would not be subject to tax (on a correctly designed policy).
The second point is simply untrue – at least if your policy is designed the right way. The 10% penalty applies only to policies that are qualified as a “Modified Endowment Contract,” which are treated more like qualified retirement plans (without going into too much detail, a MEC happens when you have contributed more than the tax-advantaged limit to a certain policy; there are some circumstances where a MEC is useful, however, we typically do not design policies this way when they are to be used for college savings).
As for loans…
Lessard says that there are also issues if parents decide to take a loan against their policy, as opposed to a straight withdrawal, as policy loans charge interest and require a payback schedule.
Yes, it’s true: Policy loans are subject to interest. However, the interest rates are typically low, and don’t vary much. They are often similar to – or lower than – the interest rate on a student or parent educational loan.
The statement about the payback schedule is simply false. None of the policies we use require any specific payback schedule, and this is one of the things that parents love about them in paying for college! As opposed to a student loan, which requires a certain monthly payment to be made every month, whole life policy loans offer unstructured loan payments, meaning that parents can pay back the loan on their own schedule, at their own convenience and budget level. Even better, once the loan is paid back, the parents may then use the funds again tax-free for their next child – or for retirement, or any other goal that they wish – a benefit that no other college savings plan can boast!
There’s also the fact that, if a parent takes a large sum of cash from the policy and still needs the death benefit, the policy may lapse from the lack of cash.
This could potentially happen if you do not use your policy correctly.
This is why it is absolutely imperative that any family wishing to use a whole life insurance policy to pay for college work with a qualified advisor who understands the inner workings of these types of insurance policies, and who will take the time to advise and provide proper guidance to help avoid these types of situations.
There are many other benefits to using life insurance policies as savings vehicles for college, including safety, liquidity, tax-advantaged and penalty-free withdrawals, protection from creditors,* and exemption from both federal and state financial aid calculations. Some insurance companies even offer special grant or scholarship opportunities to policy holders.
If you don’t fully understand the benefits and features of these types of policies, and you buy one from an insurance salesman who also doesn’t understand them (or doesn’t care to explain them to you), and doesn’t know how to properly structure them as a college savings vehicle, then it’s true – you may be better off investing in a 529 plan or some other college savings plan as the U.S. News article suggests.
However, if you choose to work with a qualified advisor who is intimately familiar with how these policies work and how to design them in your favor, and who will guide you personally over the years to make sure you are using your policy efficiently to achieve the maximum benefits it can provide, then a life insurance policy can be one of the absolute best ways to pay for college!
We believe there are a number of valid ways to plan and save for college and for other life expenses, and it is a shame that there is so much misinformation surrounding such a useful and foundational wealth-building tool as whole life insurance. We do our best to clearly explain the pros and cons of both safer and higher-risk financial tools, so that our clients can make the best and most informed decisions possible when developing either a college or general financial plan.
Want to learn more? Contact us today for a free evaluation! One of our qualified college funding advisors will be happy to review your plan to pay for college, and make sure you are using the best strategy to achieve your family’s goals.
*May vary by state. Consult a qualified advisor in your state to be sure.