College Funding with Life Insurance

ARE YOU LOOKING FOR MORE FLEXIBILITY WHEN SAVING FOR COLLEGE?

I speak to a lot of friends and clients who recently had babies, or have young children, and are concerned about the ever increasing cost of college.  According to the College Board’s Trends in College Pricing, the 2013-2014 average total costs (including tuition, fees, room and board) were $18,391 for students attending four-year public colleges and universities in-state and $31,701 out-of-state, and $40,917 for students at four-year private colleges and universities.  Add an additional $4,000 for textbooks, supplies, transportation and other expenses.   College costs increase at about twice the inflation rate with current increases averaging 5% to 8% per year.

Using the college cost calculator at Finaid.org, I input $22,391 as the current cost of college, a 6% increase rate and 17 years until the student enrolls in college for the first time.

$263,763 ($10,207/year @ 5%) is a staggering amount of money for most people to think about saving over the next 17 years – in addition to all of the other expenses of raising a family.  Hopefully loans, scholarships, and other aid will help to offset some of the cost, but you can’t depend on that.

The most important thing is to start saving now!  If possible, it would be wise to begin saving before you have kids so the money has the longest time to grow and compound in a safe vehicle.  The most common vehicle used for college savings is a 529 plan.  While I highly recommend a 529 plan over doing nothing, there are some things to be aware of including penalties and tax consequences if the funds are not used for education, potential for loss of principal due to market volatility, and inclusion in financial aid calculations.  Although 529 plans are commanding the lion’s share of attention when it comes to college savings, a brief discussion about the benefits and flexibility of today’s life insurance policies can demonstrate their value as an alternative or supplement to a 529 plan.

How can life insurance be used as a college funding strategy?

With the volatility in the market over the past few years, many clients desire to grow and protect their money without market risk, but do not know which vehicle to use for this goal.  Clients may not realize that they can use an insurance policy, and in particular an indexed universal life (IUL) policy, to:

• Help accumulate assets for the future in a tax efficient manner
• Protect their money from risk in the stock market
• Access their money for any need and at any age without penalty or taxes (unlike a 529 or 401k)
• Guarantee a death benefit and provide family protection to ensure goal completion

Traditional life insurance plans provide clients with the peace of mind of knowing that if they should die, their loved ones will be taken care of.  With Indexed Universal Life insurance, clients have this same level of security along with the opportunity to build cash value that can be accessed tax-free in the future, for any need, including college funding.

An IUL can be structured to minimize the cost of insurance and maximize the amount of money that is earning compound interest and accumulating within the cash value inside the policy.  The cash inside the policy earns interest based on the performance of an external index such as the S & P 500.  If the index goes up, then then cash value is credited with the increase, usually up to a cap.  If the index is negative for the year, the cash value inside the IUL does not decrease and is protected with a worse case scenario of earning 0% for the year.  Fees will still be subtracted from the cash account, but keep in mind that these fees are usually well under 1% for the life of the policy which is lower than the average fees in adviser-sold 529 plans at 1.14%.¹  The indexing feature is how the policy participates in the upside of the market with no downside risk.  The cash available to the policyholder can be quite significant after 17 years of compound interest with no risk of loss due to market volatility.

When college begins, the policy owner can access the cash inside the policy through a policy loan.  The loan is collateralized by the death benefit and is not required to be paid back, or it can be paid back over any time frame the owner desires to build additional wealth inside the policy.  Because the money is being accessed in the form of a loan, there are no income taxes to pay on this money as long as the policy is kept in-force.²  

Benefits of College Funding with Life Insurance

Life insurance can address some additional concerns – for instance, what happens to those college aspirations if the primary wage earner dies?  The death benefit of a life insurance policy can help secure those college plans and provide the money needed for college.  Other funding vehicles do not self-complete if the funder passes.

An IUL enables the parent to retain control of the funds if desired; assuming the parent is the owner of the policy.  Parental contol can be an important feature as it is always possible a child will decide against going to college, or want to use the money from a plan for another major purchase or life choice his or her parents don’t agree with.

An important additional benefit of using the cash value in life insurance to supplement college funding has to do with qualifying for financial aid.  Currently, it is not required to report life insurance policies under the federal FAFSA program and they won’t be included in the calculation to determine if the child qualifies for aid through this program.  If the child obtains a full scholarship or decides not to go to college, the insured can still use the available cash in the policy for other purposes, such as providing their own tax-free supplemental retirement income.

So what are the negatives of using cash value life insurance for college funding?  Since insurance is an underwritten product, it is contingent on the health of the insured.  Also … there is the cost of insurance that is not present in other financial vehicles, but this cost can be less than other options and you do get a death benefit with insurance.  There is a risk of policy lapse if the premiums are not paid, which would result in the loans being taxed.  This can be easily avoided by making sure premiums are paid and/or there is enough cash value in the policy to pay for the cost of insurance.  The accumulation of funds inside an IUL for college or other major expenses is a long-term strategy; the longer the funds have time to compound and grow – the higher the cash value will be.

College funding with life insurance offers self-completion, locked-in investment gains, tax-favored access to cash throughout the owner’s life without penalties, and exemption from countable financial aid assets.  This strategy offers much more flexibility, additional benefits and lower expenses than other vehicles and should be considered as part of a college funding plan and overall portfolio diversification.

¹  Wall Street Journal
²  Under current IRS guidelines