Where ever you place your child's college savings could impact his or her ability to attend college almost as much as grades and standardized test scores. According to Sallie Mae, the average family who saved for their children’s, saved 10,040 over three years, down from 13,408. Incredibly, 48% of families that saved for college, used a savings account and only 27% used Section 529 plans -- the college savings vehicle preferred by many families and financial advisers that 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, and since it has a tax-free death benefit, if the breadwinner in the family dies, you will be able to fund the child’s education in full.
Both can be used in very different ways, and both have pro’s and con’s, so let’s dive in and see which one can be right for you.
Let’s start off with 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. So basically, it’s not very flexible. With life insurance, it doesn't matter how you use the cash. A student can use life insurance savings for college, a down payment on a house, to start a business or for retirement. It also can stay in the control of the parents as well, and they can continue on paying for it to keep life insurance on them.
Let’s move on to risk. Section 529 college savings plans fluctuate with the market. Usually, many families elect to use an age-based account, whereas the child gets older it goes from an aggressive strategy to a more conservative strategy, almost like how target date funds work for retirement accounts. Whole and universal insurance policies frequently provide guaranteed returns if time is on your side. 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, just like how a mortgage has costs front loaded. After 10 or 12 years, you really start to see the earnings potential. But guaranteed returns can also 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 depend on your insurance provider and 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. To maximize earnings, families to purchase a policy with a low death benefit and to contribute the maximum allowance.
On to the most important topic for many middle-class families, financial aid. One of the major advantages to using a cash value policy for college savings is that money in an insurance plan won't reduce your financial aid. Money in a 529 college savings plan 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. You can take a loan out against your policy, and you can use it for anything you would like, without it affecting financial aid. Remember though, taking a loan against a life insurance policy 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. This is the most important factor to remember. If you are going to use insurance to fund an education, if the policy lapses, there would be large complications. Families with low assets are already protected from losing federal financial aid dollars. According to the Department of Education, families can hold up to $74,000 in assets, including real estate outside the primary home, stock market investments, savings accounts and college saving vehicles, without impacting their federal aid. Exactly how much depends on the age of the oldest parent.
Now on to the last part, cost. Section 529 administrative and advisory costs can range from 0.25 percent to 1.85 percent according to Morningstar, but charges on cash value insurance policies can easily top 2 percent. To reduce the costs, families should ensure the student rather than listing him or her as the beneficiary. The mortality charges are going to be much less, policies for young, healthy kids are substantially cheaper than those for adults. If you are listing the parent as the insured, you may want to go with a hybrid product, because if the breadwinner passes away unexpected, the policy will pay out a tax-free death benefit that would be able to be used to pay for college. Besides paying higher administrative and advisory costs, 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. 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.
Investors should carefully consider college saving plan and/or mutual fund investment goals, risks, charges and expenses before investing. To obtain a 529 plan disclosure document or mutual fund prospectus, which contain this and other information, please call your Registered Representative at (718)551-7131. You should read the 529 plan disclosure document and/or mutual fund prospectus carefully before investing and consider whether your or the account beneficiary's home state offers any state tax or other benefits that are only available for investments in its qualified tuition program.
The cost and availability of life insurance depends on factors such as age, health, and type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that you are insurable by having the policy approved. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications.