How Life Insurance Can Fund A 529 Plan

Permanent life insurance and 529 plans are two different ways to create college funds for children. Permanent life insurance includes a savings feature that can be used for college expenses, but it comes with costly fees. On the other hand, 529 plans are state-run and similar to a Roth 401(k) or Roth IRA, but intended for education savings. 529 plans allow tax-deferred saving with tax-free withdrawals, but they count as an asset when applying for financial aid.

Pros and cons of using life insurance to fund a 529 plan

Permanent life insurance can be used to fund a 529 plan for your child's college education. However, there are pros and cons to using this method.

Pros of Using Life Insurance for a 529 Plan

• Flexibility: If your child decides not to go to college, you can use the cash value for anything without the penalties or taxes that come with a 529 plan.
• Not just for tuition: You can use the cash value to cover emergencies, pay down debt, or boost your retirement savings.
• Tax-free withdrawals and loans: You can take out loans or make withdrawals without paying taxes, as long as you don't exceed what you've paid into the policy.
• Doesn't affect financial aid: The cash value in a permanent life insurance policy is usually not factored into financial aid calculations, so your child could still qualify for financial aid.

Cons of Using Life Insurance for a 529 Plan

• No tax deductions: Unlike a 529 plan, you don't get any tax breaks for contributing to a life insurance policy.
• High costs: Permanent life insurance comes with high upfront fees, ongoing expenses, and insurance charges.
• Time to build cash value: It can take 10 years or more for your cash value to surpass what you've paid in premiums, so it's not a quick way to build up funds for tuition bills.
• Borrowing costs: While you can borrow against the cash value, you'll have to pay interest on the loan, and if you don't pay it back, it will reduce the death benefit your beneficiaries receive.
• Qualifying for coverage: Getting a life insurance policy requires the insured person to qualify based on health and age, which may not be feasible for everyone.

How permanent life insurance works

Permanent life insurance is designed to provide coverage for your entire lifetime as long as you continue to pay the premiums. Unlike term life insurance, which covers a set period, permanent life insurance typically pays out a death benefit no matter when you pass away. Permanent life insurance policies tend to be more expensive than term life insurance policies because they combine a death benefit with a savings component that earns interest on a tax-deferred basis.

The two primary types of permanent life insurance are whole life and universal life. The cash value of whole life insurance grows at a guaranteed rate. Universal life insurance also contains savings and a death benefit, but it features more flexible premium options, and its earnings are based on market interest rates. Variable life and variable universal life also provide expanded options to invest the cash value in mutual funds and other financial instruments.

Once you've picked the policy that's right for you, it's important to thoroughly research the firms you're considering to ensure you get the best life insurance available.

Here's how permanent life insurance works:

Coverage

Permanent life insurance provides coverage for the full lifetime of the insured person. While it is more expensive than term insurance, permanent policies combine a death benefit with a savings component that earns interest on a tax-deferred basis. This means that the policyholder pays no taxes on earnings as long as the money stays in the policy.

Death Benefit

Permanent life insurance policies provide a death benefit to the policyholder's beneficiaries. This benefit is typically paid out income tax-free and can be used for various purposes, including paying for college expenses or supporting children's education and living expenses if a parent passes away.

Savings Component

Most permanent life insurance policies have a cash value savings component that grows over time. This cash value can be accessed by the policyholder during their lifetime through loans or withdrawals. However, taking out the policy's cash value will reduce the future death benefit for heirs. The cash value can be used for various purposes, such as paying for medical expenses, college education, or supplementing retirement savings.

Premium Payments

Permanent life insurance policies have higher premiums than term life insurance policies due to the added savings component. The premium payments for whole life insurance are fixed and guaranteed, while universal life insurance offers more flexibility, allowing policyholders to adjust their premium payments and death benefit within certain limits.

Investment Options

The cash value of permanent life insurance policies can be invested in different ways, depending on the type of policy chosen. Whole life insurance offers a guaranteed rate of return, while universal life insurance ties the cash value to market interest rates or specific investments. Variable universal life insurance allows policyholders to choose and manage their investments, but they assume the risk for any losses.

Pros and cons of a 529 plan

A 529 plan is a tax-advantaged savings account specifically designed to help families set aside money for education expenses. Here are some pros and cons of 529 plans:

Pros

• Tax benefits: Contributions grow tax-deferred, and withdrawals for qualified education expenses are tax-free. Some states also offer tax deductions or credits on contributions.
• High contribution limits: Many states allow significant contributions, often well beyond the cost of a four-year college education. For example, in 2024, up to $18,000 qualifies for the annual gift tax exclusion.
• Flexible use: Can be used for a wide range of educational expenses, including tuition, books, and even room and board. It can also be applied to K-12 education and student loan repayment.
• Control: The account owner retains control over the funds and can change the beneficiary if needed.

Cons

• Penalty for non-educational use: If the funds are not used for qualified education expenses, withdrawals face a 10% penalty and income taxes on earnings.
• Limited investment options: Your investment choices are often restricted to those provided by the state's plan, which may not offer the most diverse or competitive options.
• Impact on financial aid: A 529 plan owned by the student or parent can affect financial aid eligibility, as it's counted as an asset.

How to withdraw funds from a 529 plan

Withdrawing funds from a 529 plan can be done in a few different ways, but there are some important rules to follow to avoid paying extra taxes or penalties. Here are the steps to withdraw funds from a 529 plan:

Step 1: Calculate Your Qualified Education Expenses

You can withdraw any amount from your 529 plan, but only qualified distributions will be tax-free. Qualified expenses include tuition, fees, books, supplies, equipment, room and board (if the student is enrolled at least half-time), and up to $10,000 per year in K-12 tuition expenses. To calculate your qualified expenses, add up your college expenses and K-12 tuition, then subtract any tax-free educational assistance, such as scholarships or educational assistance through a qualifying employer program.

Step 2: Determine When to Withdraw

Make sure to take 529 plan distributions during the same year you paid for the qualified expenses. Withdrawals should match up with the current calendar year, not the academic year. For example, if you withdraw funds in January, make sure they are used for expenses paid in that same calendar year.

Step 3: Decide Which 529 Plan Account to Withdraw From

If you have multiple 529 accounts, consider tapping into the account with the higher earnings ratio once your child gets to college to lock in maximum tax savings. If your child graduates and you still have money left in your 529 plans, you can minimize non-qualified distribution tax costs by leaving the lowest-growth account for last.

Step 4: Complete a Withdrawal Request

You can usually request a withdrawal on the 529 plan's website, by telephone, or by mail. The withdrawal request form will typically ask for information such as your name and social security number, the beneficiary's name and social security number, and the 529 plan account number. If you are taking a partial withdrawal, you can select the portfolios you wish to withdraw from. Avoid making the distribution payable to the account owner, as this may result in a higher tax liability. Instead, request the distribution be made payable to the beneficiary or their college/school.

Best Practices to Follow When Withdrawing

• Withdraw the right amount – If you are the parent or student, it is generally best to take the maximum of qualified withdrawals as early as possible. This ensures that the funds do not go to waste if the student drops out or changes their career path. However, if a grandparent or third party owns the account, withdrawals should be carefully timed to minimize their impact on the FAFSA.
• No double-dipping – As a 529 account owner, you cannot reimburse yourself for expenses already paid with tax-preferred funding. For example, you cannot claim the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC) on expenses you've already claimed with 529 assets.
• Time disbursements carefully – Withdrawals should be taken in the year the expense is incurred to avoid being considered a non-qualified withdrawal and subject to tax and penalties.
• Disburse to the right entity – Most plans allow disbursement to the account owner, the beneficiary, or directly to the school. Avoid making withdrawals to yourself unless you are also the student to prevent administrative headaches.

Comparison of 529 plans and brokerage accounts

529 plans and brokerage accounts are two of the most common ways to save for a child's college education. Here is a comparison of the two:

529 Plans

529 plans are tax-advantaged savings accounts specifically designed for education expenses. The earnings in a 529 plan grow tax-free at the federal level, and withdrawals for qualified education expenses are also tax-free. In addition, many states offer tax deductions or credits on contributions. 529 plans offer high contribution limits, typically ranging from $235,000 to $575,000, making them suitable for families looking to save large amounts for education. However, if the funds are used for non-educational expenses, there are tax penalties when the money is withdrawn.

There are two main types of 529 plans: savings plans and prepaid tuition plans. Savings plans are the more common type, where the account holder contributes money that is invested in mutual funds, ETFs, or other investment options. Prepaid tuition plans allow you to lock in today's tuition rates at participating in-state public colleges and universities.

The control of a 529 plan rests with the account owner, typically the parent or grandparent. The owner can change the beneficiary, make investment choices, and decide on contributions and withdrawals. However, if the beneficiary reaches the age of 18, the owner has the option to transfer ownership of the account.

Brokerage Accounts

Brokerage accounts, on the other hand, are regular investment accounts offered by financial institutions. They provide a broad range of investment options, including stocks, bonds, mutual funds, and other securities. Brokerage accounts do not offer the same tax benefits as 529 plans, and there are no specific tax benefits for education savings. Any profits made on the assets in the account are taxed as capital gains.

Brokerage accounts have no restrictions on withdrawals, providing more flexibility. There are also no contribution limits, but contributions are made without the tax benefits of a 529 plan, and taxes must be paid on any gains when withdrawing funds.

When it comes to financial aid impact, assets in a parent-owned 529 plan are considered parental assets and assessed at a maximum rate of 5.64% for federal financial aid calculations. In contrast, assets held in the student's name, such as in a brokerage account, are assessed at a higher rate of 20%, which can reduce the financial aid received.

Both 529 plans and brokerage accounts have their advantages and disadvantages. 529 plans offer significant tax benefits and can be a great option for families looking to save specifically for education expenses. On the other hand, brokerage accounts provide more investment options and flexibility in using the funds but lack the tax advantages of 529 plans. The best option depends on an individual's financial situation, goals, and risk tolerance.

Frequently asked questions