Where you store your child’s college savings could impact his or her ability to attend college as much as grades and standardized test scores. There are many different savings plans out there to choose from. This article will touch on Section 529 plans and introduce permanent life insurance as an alternative tool for college savings. To understand why you would choose permanent life insurance as an alternative to Section 529 plans, you have to understand what they are.
Section 529 plans are educational savings plans operated by a state or educational institution that are designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Code, which created these types of savings plans in 1996. Section 529 plans are typically sponsored by large mutual fund companies and are sold by licensed securities representatives. These offerings vary considerably in commission, fees and expense structure, investment options offered, limitations on investment or beneficiary changes and other factors. The structure is somewhat similar to a mutual fund, but unlike a mutual fund, Section 529 plans restrict changes in investment options to once per calendar year, unless they are coupled with a change in beneficiary. New deposits may be invested in any of the options available in the plan.
Section 529 requires sponsoring states to restrict the maximum amount that may be invested in any one plan. Different states interpret these restrictions in different ways. There are also some tax benefits. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to the plan participant. Some states (but not California) offer tax incentives to investors as well. The top 7 benefits of 529 plans include: federal tax benefits, state tax benefits, the donor (parent) retains control of funds, they’re low maintenance, simplified tax reporting, some flexibility and reasonable deposits are allowed.
But having a robust section 529 plan could hurt a student’s chances of tapping into sources of financial aid. That’s because section 529 plans are savings plans, and therefore are included in the parents’ assets when calculating the expected family contribution for financial aid eligibility. According to the Department of Education, the money in a 529 plan can subtract up to 5.6 cents in financial aid for every dollar stored in the account. But cash value policies, like permanent life insurance, are sheltered from the federal financial aid formula. That’s because life insurance cash value is not considered an asset of the parent or the student for purposes of determining eligibility for financial aid.
So what is permanent life insurance? It is an umbrella term for life insurance plans, such as whole life insurance or universal life insurance, that don’t expire (unlike term life insurance) and combine a death benefit with a savings portion. The sum assured is due to be paid out at the end of the policy and the policy accrues a cash value, against which the policy owner can borrow funds. Because of this, permanent life insurance can also be used as a college savings vehicle.
Although the savings element in permanent life insurance contracts is often considered secondary to the death benefit, there are several features that make life insurance plans particularly useful for education savings. The principal features are exemption of cash value accumulation from income taxes, lack of restrictions on uses of funds withdrawn or borrowed from the policy, the self-funding nature of the vehicle in the event of premature death, flexibility of contributions, and particularly in the case of whole life insurance, the predictability of positive investment returns.
Unlike 529 plans, funds stashed in a life insurance policy won’t count against a family’s financial aid award and policies have no yearly contribution caps, making them attractive to high earners who have maxed out other tax-deferred savings vehicles. Permanent whole life and universal life plans also frequently come with guaranteed returns, so families will never lose funds.
Life insurance can be effectively used as an alternative to 529 college savings plans. But not every permanent life insurance policy is designed to maximize cash value. It is important to own a properly designed policy. Because the Internal Revenue Code limits the amount of cash that can be paid into a life insurance policy without destroying its tax-favored status, the policy intended to fund college education should be carefully designed to accomplish a combination of the maximum advantage (highest cash value) and the lowest cost of life insurance itself (lowest death benefit).
Before considering a permanent life insurance policy for your family, You’ll want to be aware of how the insurance policy works and of any surrender charges that could be incurred by withdrawing too many funds too early.
At Westface College Planning we have expertise in designing cash value life insurance contracts that are optimized to match your college and retirement savings as well as funding needs. Give us a call to learn more at 650-587-1559. We can help you navigate the complexities of college planning to get your family on the right financial track before your child heads off to college.
I discussed the topic of “College Savings Accumulation in Cash Value Life Insurance Policy,” with my guest Don Blanton, Founder & President of Moneytrax, a software and training company that helps financial professionals communicate financial concept to their clients. Listen to this broadcast on YouTube: Part 1 – Part 2.
Photo Credit: Luke Hayfield Photography