Should You Use Life Insurance to Pay for College?
With today’s high cost of college, many families are looking for creative ways to save more to pay for their children’s education. One topic that is hotly debated when it comes to paying for college is whether a life insurance policy is a good option to use as a college savings vehicle. For example, this article in U.S. News & World Report lists 3 reasons why this is a bad idea.
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 that may be misleading.
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 discussed in the article, it does not sound as if they are talking about the same type of life insurance policies that we use in helping our families plan for college...
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 would recommend for college savings.
The Whole Life policies that we typically use for this purpose have level premiums that never increase, and when you are ready to stop contributing entirely, 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 tries to pose as reasons why you shouldn't use whole life insurance policies to pay for college – and our responses and corrections:
Reason 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 does admit that there are several life insurance companies that allow agents to take reduced commissions, which puts more money into the policy for its holder – but he says that’s "rare."
The “rare” type of company (and policy) mentioned above is exactly what we typically recommend for our clients...
And this next point from the article is exactly why we use them:
- “If a life insurance policy has 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.
Reason 2: High Cost
- The article points out that 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 it's true that 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.
However, 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.
So the question to consider is...
Do you think that it is wise to house most or all of your college savings in a vehicle that is unpredictable and could potentially lose money just when you need it?
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.
Reason 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 the article goes on to state that 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.
But the truth is that this should never happen if your policy is structured correctly – and if you are working with an insurance professional 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 (assuming your policy is correctly designed).
Garner's second point is simply untrue – at least if your policy is set up the right way.
The 10% penalty only applies 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!
- The article also points out the fact that if a parent takes a large loan from the policy and doesn't pay it back, the policy could lapse.
And it's true - 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 college planning professional 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 also a number of 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 the families of 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 thoroughly 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.
It's also true that the garden variety "off-the-shelf" type of life insurance policy truly may not be the best choice for most families. But, if you are using the right type of life insurance, and it is properly structured to achieve maximum efficiency, and you understand how to use it correctly, life insurance is a truly unique financial vehicle with some useful benefits that can definitely work to your advantage in this arena.
You just want to make sure you are working with a qualified financial professional who is intimately familiar with how these types of 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 - both when paying for college, and beyond.
There are plenty of valid ways to plan and save for college and for other life expenses, and we feel it is a shame that there is so much misinformation surrounding such a useful and foundational wealth-building tool as whole life insurance. In every situation, we try to 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 plan or a more general financial plan.
Want to learn more? Contact us today for a free evaluation! One of our qualified college funding professionals 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 specific goals.
* In most states. Consult a qualified tax advisor or attorney for your state to be sure.
This document is for educational purposes only and should not be construed as legal or tax advice. One should consult a legal or tax professional regarding their own personal situation. Any comments regarding safe and secure investments and guaranteed income streams refer only to fixed insurance products offered by an insurance company. They do not refer in any way to securities or investment advisory products. Insurance policy applications are vetted through an underwriting process set forth by the issuing insurance company. Some applications may not be accepted based upon adverse underwriting results. Optional riders may have an additional cost. Life insurance policy loans will reduce the cash value of the policy and the death benefit. Unpaid policy loans may accrue interest that could lead to policy lapse, loss of tax benefits, or both. Death benefit payouts are based upon the claims paying ability of the issuing insurance company.