Life insurance is often recommended as a preferred vehicle when planning for future educational expenses. Many, for various reasons, advocate life insurance over alternatives, such as 529 plans, when advising individuals and families contemplating the best way to address future college expenses.
There is no doubt that accessing one’s life insurance policy can provide certain benefits when paying for college, but it is important to note the distinction when using it as the primary vehicle to plan, versus when paying, for college and other future educational expenses.
There has been much discussion on this topic and, it appears, much confusion, which may be attributed to an “apple versus oranges” analysis. This article intends to distinguish between the pros and cons of paying, versus of planning, for college costs with life insurance. The analysis reveals that there is a significant difference between these two concepts that one should appreciate before proceeding on a strategy.
While there is no single vehicle or strategy that applies to every situation, there are some general observations that should be considered when financially preparing for future education costs, especially when insurance is proposed.
Background on Life Insurance
Life insurance is available in two basic forms. The first is term insurance, which is more similar to other forms of insurance consumers typically purchase, such as auto, home, liability etc. Term insurance provides coverage on stated terms and premium price for a specified period of time, often annually, subject to renewal at a higher premium reflecting the older age and thereby higher risk of the insured. Similar to auto and homeowners’ insurance, term policies have no value at the end of its term.
Whole life insurance
Another type is “permanent” or whole life insurance, which is more of a hybrid of term insurance and an investment at the same time. These policies offer a premium fixed for the life of the policy at the time when such policy is underwritten, with the original premiums typically higher than term policies for the same insured for the same coverage in most cases. They are designed to accrue value after a portion of the premiums paid are applied to address the risk of a claim. Such value, known as “cash surrender value” (”CSV”) accrues tax-deferred over time based on the type of policy, the amount of premiums paid and the policy dividend the company declares each year.
As such value builds up over time, the policy owner can access such CSV by terminating or “surrendering” such policy to the insurance company but that typically results in taxable income based on the reported gain.
One could sometimes also simply withdraw any paid-up additional insurance of such policy but the reduced value results in less coverage and such amounts withdrawn may be taxable income.
A more tax-friendly strategy in most cases is to borrow from the company against a high percentage of such policy’s CSV, at a fixed rate of interest. Such loan interest rate would typically be 8%, for example, with no fixed repayment schedule but with any deferred interest payments being added to the principal amount of such loan.
Both term and whole life insurance consist of contracts whereby the insurance company is to pay a claim equal to the amount of coverage acquired upon the insured’s death. The policy’s beneficiaries are to be provided with financial resources to fill the income and/or asset void resulting from the insured’s death, with needs and priorities that vary among such beneficiaries.
Some, such as myself, have maintained both types of life insurance with varying amounts of coverage determined by the need and purpose for coverage and the cost of each policy. It is generally regarded as prudent to have either type or both of life insurance when one’s total, including future, liabilities exceed their current assets, since such insured individual’s income will no longer be available to address such liabilities.
While that death protection is the primary benefit to be derived from both types of policies, there are several other reasons given for purchasing life insurance, such as providing for a way to pay future college costs, that may lead one to opt for a whole life policy.
Benefits of Life Insurance to Pay College Expenses
There are several benefits to using a whole life insurance policy to pay for college, or other expenses.
First, if the insured individual was to be responsible to pay all or some of the costs of college and they passed away before doing so, the death benefit paid on the policy would be available to pay some or all of such costs. The receipt of insurance proceeds is not considered taxable income making the opportunity to pay education costs tax-free. If one other than the insured owns the policy, such asset is also generally excluded from their taxable estate.
Most, however, are alive when accessing their policy to pay for expenses such as college and can borrow most of the CSV without proving any credit worthiness. As true with any loan, the proceeds are usually tax-free to the recipient, who is able to apply such funds to any purpose, including paying college costs.
Other benefits include the exclusion of life insurance cash surrender value as an eligible asset when determining the expected family contribution (recently re-labeled as “student aid index”) for need-based financial aid when submitting the federal government’s form, Free Application for Federal Student Aid (“FAFSA”), for each year while matriculated.
Thus, as college costs become due, one should consider all available resources to pay for college costs including the CSV of one’s whole life insurance.
Concerns When Planning for Future Education Costs with Life Insurance
There are a number of factors to consider when choosing the best strategy when planning to pay for college tuition and other future educational expenses. While acknowledging the benefits of owning a whole life policy to pay as described above, the question as to whether it is the best “plan” is another matter.
To be insured, one must be insurable, i.e., in good enough health for the insurance company to assume the risk of a potential death claim. Often an individual with health issues cannot acquire insurance or, if approved, the higher premiums assigned to such policy make it less attractive as an investment vehicle. This issue can sometimes be addressed by insuring the student when they are very young, if the owner has an insurable interest in the insured, which also may allow for a lower premium than a policy on an older owner.
The life insurance policy needs to be in place for a number of years to accumulate the CSV and thereby have any funds to access. As mentioned, earlier, the CSV will depend on a number of factors including the amount of premiums paid over time and the dividends declared each year by the insurance company. One should assume a minimum of 10 years for the CSV to achieve some value.
3. Mortality expense
A large portion of life insurance premiums paid will not have gone toward accumulating CSV as they will have been used to address certain costs relating to the policy, including the insurance risk of a death claim. This “mortality expense” results in less funds being invested within the policy toward its CSV and therefore less than available if such funds were invested in most types of investment accounts.
To access the funds tax-free, one must borrow against the CSV. As a result, such loan will accrue interest which, together with the principal amount borrowed, reduces the coverage payable under the ultimate death claim. Periodic interest payments on the outstanding loan are encouraged as any unpaid interest is added to the outstanding loan balance.
5. Additional life insurance premiums
The policy must remain in force which often means the premiums must continue to be paid, in addition to any loan payments. The net cost of such premiums due may rise given the policy dividends, which may have been applied to pay some or all of the premium, are reduced or eliminated due to the outstanding loan. This means more financial obligations on the family contributing to more financial stress.
6. Potential financial aid impact
While exclusion of the CSV on FAFSA is appealing, it would be wrong to assume that the needs-based financial award will be greater than what one may have paid into a whole life policy. No one can predict or expect what the student’s financial aid award will be by any college whether it be next year or 10 years from now.
Further, although the current FAFSA formula excludes CSV, there can be no assurance that it will remain so in 10, 15 or even 20 years later, when such child is to be applying for financial aid. It is also possible other assets could then also be excluded as an eligible asset for FAFSA purposes, thereby reducing the appeal of whole life insurance for such reason.
529 plans as an Alternative to Life Insurance When Planning for Future Education Costs
While permanent life insurance offers certain attractive features for paying college costs, when developing a plan to pay such costs, more traditional saving and investing vehicles such as 529 plans need to be considered.
Anyone can open and fund one or more 529 accounts. There is no limitation based on health, insurable interest, or on income, age or any other personal factor of the account owner, or designated beneficiary, or successor owner, who are both different from the account owner in most instances.
2. Availability of funds
529 plans immediately credit the 529 account owner with all earnings on the principal amount paid into or invested into each account, as distinguished from a whole life policy, which only credits a portion of premiums paid to CSV. As a result, more funds are available to the account owner whenever needed.
3. Tax benefits
A 529 plan account is tax-deferred, similar to permanent life insurance, and may also be spent free of federal and state tax for qualified educational expenses, but without a loan and the resulting accruing interest and repayment obligation, if one wishes to restore the full coverage.
529 plans pay earnings, including interest, but don’t charge interest as borrowings against life insurance policies do. Repaying such loan, with interest, makes the cost of college even greater than its current lofty price tag and results in substantially higher outlay than if investing and earning on such sums.
There is no ongoing obligation to pay into a 529 plan. One may contribute as much as $500,000 at once, or over time, to each more account, but can also start with less than $1,000 and not be required to invest any more, at any time.
6. Additional benefits
There are numerous “collateral benefits” to 529 accounts when planning such as state tax deductions or credits, at varying levels, that are offered by most states for contributions to a 529 account. Unique estate tax benefits and creditor protection are often available from 529 accounts.
7. Financial aid impact
The maximum weight assigned to 529 accounts value as an eligible asset by FAFSA is 5.6% when such account is owned by a parent or student through an UGMA/UTMA account, and 0% weight when owned by a grandparent, thus diminishing the comparable advantage of excluded CSV. Further, legislation has been introduced eliminating the value of the 529 account as an eligible asset for purposes of FAFSA, though it cannot be guaranteed such proposal when be enacted, if at all.
8. Control of the account
The 529 account owner maintains control over their account at all times, including immediate access to all amounts contributed, plus any earnings and net of any investment losses. They have access to over 100 plans and thousands of investment options and can change ownership of the account of most plans at any time. There is no period of years required (as opposed to 10+ years for the CSV) but rather the 529 account owner can choose to access their funds at any time, either for a tax-free distribution for qualified educational expenses or any other purpose with the earnings thereon subject to tax and an additional tax penalty of 10% of such earnings.
Whole or permanent life insurance is important to family financial planning and is appropriate for most to own, or at least have, especially when significant financial obligations exist or are anticipated.
For those who can acquire term or whole life insurance and are still financially able to save and invest for future educational expenses, planning for such expenses will most likely result in funding a tax-deferred 529 account.
For those who find themselves with insufficient educational savings invested, borrowing is a very common approach to pay for college.
Whether it be through a home equity loan/line, a margin loan on an investment account or a loan on one’s whole life insurance policy, it is usually more reliable and easier than pursuing a new or additional loan from a bank or other lending source.
Simply stated, when the goal is planning for future educational expenses, 529 plans is likely the better option for most. In most circumstances, amounts paid into a whole life insurance policy will not provide as much available funds for college as the same amounts invested over the same time period in a 529 plan. This makes planning for college with a 529 plan the better option for most.
As a general rule, borrowing to pay for college should not be “the plan”. For those who don’t have the ability to plan with a 529 account and maintain insurance, however, the ability to pay college costs with a loan from a whole life policy or leveraging other assets can be a valuable option.