How Cash Value Life Insurance Affects Financial Aid Eligibility

Cash value life insurance is a type of permanent life insurance that includes a cash value feature. This means that the policyholder can withdraw or borrow money against the cash value of their policy. This can be particularly appealing as it allows the policyholder to access the money early. However, doing so will reduce the available cash surrender value and the death benefit. When it comes to financial aid, it is important to know that any cash value built up in insurance policies does not have to be included on the FAFSA (Free Application for Federal Student Aid). Therefore, cash value life insurance does not count against financial aid.

529 College Savings Plans and Coverdell ESAs

A 529 plan is a tax-advantaged savings account designed to be used for a beneficiary's education expenses. It is a state-sponsored investment plan that enables you to save money for a beneficiary and pay for their education expenses. You can withdraw funds tax-free to cover almost any type of college expense. 529 plans may also offer additional state or federal tax benefits.

There are two types of 529 plans: 529 tax advantage and 529 prepaid plans. The 529 tax advantage plan is the most popular option and has strong tax advantages. Your investments grow tax-free, and you can also withdraw funds tax-free for education expenses such as tuition, room and board, and assigned textbooks. You can use withdrawals from education savings plan accounts at any college or university, and some trade schools. You can also use your education savings plan to pay up to $10,000 per year, per beneficiary, for tuition at any public, private, or religious elementary or secondary school.

A Coverdell Education Savings Account (ESA) is a trust or custodial account set up in the United States for paying qualified education expenses for the designated beneficiary. This includes not only qualified higher education expenses but also qualified elementary and secondary education expenses. Contributions to a Coverdell ESA must be made in cash and are not deductible. The total contribution to all accounts on behalf of a beneficiary in any year cannot exceed $2,000.

The designated beneficiary of a Coverdell ESA can receive tax-free distributions to pay for qualified education expenses. These distributions are tax-free as long as they do not exceed the beneficiary's qualified education expenses. If a distribution exceeds these expenses, a portion of the earnings is taxable to the beneficiary. Coverdell ESAs offer tax-free investment growth and tax-free withdrawals when the funds are spent on qualified education expenses. However, they have much lower maximum contribution limits per child and are only available to families below a specified income level.

Custodial accounts

Cash value life insurance is a type of permanent life insurance that includes a cash value savings component. The policyholder can use the cash value for many purposes, including withdrawing cash from it, borrowing against it, or using it to pay policy premiums. The cash value of life insurance earns interest, and taxes are deferred on the accumulated earnings.

Now, on to custodial accounts:

Pros of Custodial Accounts

Cons of Custodial Accounts

One of the biggest drawbacks of custodial accounts is their potential negative impact on financial aid eligibility. Because the money in a custodial account is considered an asset of the student, it can reduce eligibility for need-based financial aid by up to 20% to 25% of the asset value. This is a much higher reduction than for a 529 plan account owned by a dependent student or their parent.

Additionally, custodial accounts do not offer the same tax advantages as 529 plans, and the beneficiary cannot be changed. Once the account is established, the beneficiary is irrevocable.

Impact on Financial Aid

Taxable investment accounts

A taxable investment account is a way to buy and sell assets like stocks, bonds, and exchange-traded funds. You can open one at an online broker or a robo-advisor. The word "taxable" means that when you earn dividend income or profits from the sale of assets, they must be reported to the IRS for tax purposes. Depending on how long you owned an asset before selling it, your profits could be taxed at your normal income tax rate or a long-term capital gains tax rate. Dividends generally qualify for the latter treatment, regardless of how long you've owned a stock.

When to Choose a Taxable Investment Account

There are several scenarios where investing in a taxable account would make sense:

• Benefit from Additional Liquidity: Liquidity is the main reason an investor might pursue a taxable investment account. There are no age restrictions on when money can be accessed with taxable accounts, unlike retirement plans such as 401(k)s, annuities, and traditional IRAs, which have age restrictions and penalties for early withdrawal.
• Save More for Retirement: If you've already maxed out your contributions to your 401(k) or IRA and have additional funds to invest, a taxable investment account is a good option.
• Avoid RMDs in Retirement: If you're concerned about required minimum distributions (RMDs) in retirement, a taxable account can allow you to leave your money in the market for a longer period.
• Greater College Savings Flexibility: If you're saving for education in a 529 plan or a Coverdell account, you're limited to qualified educational expenses. A taxable investment account can give you more flexibility to pay for other expenses.
• Complement a 529 Plan: A taxable brokerage account can complement your 529 account, letting you pay for expenses like room and board, travel, and incidental costs.
• More Investment Options: A taxable investment account offers more options for investors who want control over their investment strategies, such as investing in cryptocurrency or options trading.
• Maximize an Inheritance: With recent changes to inheritance tax laws, it may make sense to spend retirement account funds during your lifetime and pass down funds in taxable accounts, which don't have withdrawal schedules. Additionally, investments in a taxable account qualify for a tax-free stepped-up basis when you pass away.

How to Open a Taxable Investment Account

If you decide that a taxable investment account is right for you, here are the steps to open one:

• Decide where to open an account—via a financial advisor or an online broker.
• Fund your account so you have cash available to make your investments. You can link an existing bank account to make this process easier.
• Research investments and make selections based on your investment timeline, risk tolerance, and savings goals.
• Remember to rebalance your portfolio and adjust your investment strategy as you approach your goals.

Life insurance and annuities

Any cash value built up in insurance policies does not have to be included on the FAFSA (Free Application for Federal Student Aid). However, if you're considering moving your child's money into an annuity, be aware that if you need to use those funds to pay for college, the distribution will show up as income in future years. This will have a more detrimental effect on financial aid than simply holding the funds in savings or transferring them to a 529 plan.

Home equity

I could not find sufficient information about whether cash-value life insurance counts against financial aid. However, here is some information about home equity and financial aid:

The loan-to-value ratio for home equity loans can go up to 80% or 90%, depending on the lender. It is important to note that MIT FCU, for example, does not offer home equity loans or lines of credit for properties in Texas or those currently under construction or renovation.

Frequently asked questions