Life Insurance: Impacting College Dreams And Realities

Life insurance is an important financial consideration for college students and their parents. While it may not seem like a priority for students, who are often more focused on their studies and graduating on time, there are circumstances in which having life insurance can be beneficial. For example, if a student has co-signed on private student loans, life insurance can protect the co-signer from having to pay off the loan in the event of the student's death. Life insurance can also provide financial support for a student's spouse, children, or other dependents. Additionally, parents who have taken out loans to finance their child's education may want to consider life insurance to cover these expenses if the student passes away. While life insurance can provide financial protection, it is important to carefully weigh the pros and cons, as it may not always be the best option for saving for college due to high costs and complex withdrawal processes.

High costs and withdrawal issues

The high costs and difficult withdrawals associated with life insurance policies can cause significant problems for families relying on them for college savings. Here are some key considerations regarding the high costs and withdrawal issues of using life insurance for college savings:

High Costs:

Life insurance policies, particularly permanent life insurance, tend to have high fees and charges. Upfront and recurring fees can be substantial, and it can take years for the cash value of the policy to exceed the total amount paid in premiums. For example, 50% or more of the first-year premiums typically go towards paying the insurance representative's commission. Additionally, annual expenses, including account fees, mortality and expense risk charges, sub-account fees, rider fees, and surrender charges, can add up to a significant amount. These high costs can quickly erode the savings intended for college.

Withdrawal Burdens:

Withdrawing funds from a life insurance policy to pay for college can create unexpected challenges. Parents may have to pay income tax on the withdrawn amount if it exceeds the premium they have paid, as well as a potential 10% penalty if they are under a certain age. Taking out a loan against the policy, instead of a straight withdrawal, also has its drawbacks. Policy loans charge interest and require repayment, and if the parent takes a large sum from the policy, the policy may lapse due to lack of cash.

Alternative Options:

Due to the high costs and withdrawal issues associated with life insurance policies, financial experts often recommend alternative savings vehicles for college, such as 529 plans, Roth IRAs, or Coverdell Education Savings Accounts. These options offer tax advantages, flexibility, and lower expenses, making them more suitable for saving for college.

Impact on Financial Aid:

While life insurance policies are not included in the FAFSA financial aid calculations, they are considered in the CSS Profile, which is required by many colleges that are generous with financial aid. Therefore, the expected benefit of increased financial aid by using life insurance may not materialize for many families.

In conclusion, while life insurance policies offer flexibility and can be used as a supplement to college savings, they are not ideal as the primary savings vehicle due to their high costs and withdrawal issues. Families should carefully consider the potential challenges and explore alternative options to ensure they can effectively save for their child's college education.

Agent practices and commissions

Life insurance agents are typically paid via sales commissions. This can sometimes interfere with the way a life insurance policy is structured, and some argue that the wrong product is used. Agents are paid on target premiums, so the higher the target premium, the larger the commission. This means that policies are often sold for the agent's benefit, not the client's.

Commissions can be a large percentage of the premium in the first year, with agents receiving anywhere between 40% and 115% of the first-year premium as commission. In subsequent years, the commission is lower, usually between 2% and 10%. Whole life insurance plans tend to fetch the best commission, with over 100% of the total premium paid by the client in the first year. Universal life insurance plans also have high commission values, while term insurance policies fetch lower commissions.

Agents can also earn a commission when their clients renew or pay premiums for their life insurance schemes. This means that agents have an incentive to promote policies with higher premiums, like permanent life insurance. As a result, some agents may recommend permanent policies, even if the commission percentage is the same, since the total commission they stand to earn is higher.

In some states, agents are required to disclose the amount they are earning in commission if the client requests it.

There are some life insurance companies that allow agents to take reduced commissions, which puts more money into the policy for its holder. However, this is rare.

Pros and cons of life insurance and 529 plans

Pros of Life Insurance

Life insurance offers greater flexibility than a 529 plan. If your child decides not to attend college, the money in a 529 plan will be subject to income tax rates and a 10% tax penalty if you decide to withdraw it. With life insurance, you don't have to worry about this tax headache. You also have the option to name another relative as the beneficiary, pay off student loans, or roll the money into a Roth IRA for the beneficiary.

Life insurance is also not included in financial aid calculations, whereas up to 5.64% of parental assets are counted in the applicant's Student Aid Index (SAI) for each year of college when using a 529 plan.

Cons of Life Insurance

Life insurance has high upfront and recurring fees. For example, 50% or more of your first-year premiums will typically be used to pay the insurance representative's commission. It can take 10 years or more for the cash value of your policy to surpass what you've paid in premiums, so it's difficult to make a case for life insurance as a way to build up assets to pay for college.

Life insurance policies also charge upwards of 2% per year in administrative and investment costs, which can eat into your earnings.

Pros of 529 Plans

529 plans offer tax breaks. You can invest in a range of mutual funds and your earnings will grow tax-deferred. Withdrawals from a 529 plan for qualified education-related expenses are tax-free. Most states also offer a state tax deduction or credit for your contributions.

Cons of 529 Plans

The savings in a 529 plan count as an asset when you apply for financial aid, which can reduce your eligibility for certain types of student aid. A life insurance policy, on the other hand, doesn't count as an asset.

Covering dependents

Life insurance can be a good idea for college students who have people depending on them financially. This can include children of their own or parents or other relatives who rely on them for income or help with daily tasks. In these cases, a life insurance policy can help care for loved ones if the college student dies.

Even if a college student does not currently have dependents, they may want to consider buying coverage for the future. It is generally cheaper and easier to buy life insurance at a young age. Getting a term life policy while in college may be very affordable, and buying a policy while young and healthy can ensure protection is in place before any pre-existing conditions develop that could complicate the purchase of coverage later on.

For example, a college student who plans to get married and start a family after graduating may benefit from buying an affordable policy that will be in effect for the next 30 years or so. Once their plans come to fruition, the premiums on that policy will remain very low, and it will offer important protection for their future spouse and children.

In addition, college students with loved ones who would face serious financial hardship if they had to cover funeral costs may want to buy at least a small policy to spare their family that burden should tragedy strike.

It can be challenging to determine how much life insurance to buy, especially if the policy is being purchased with the plan to care for future dependents. Generally, a person buying life insurance will want enough coverage to:

• Replace their income for the number of years their family will need it
• Cover their mortgage loan
• Pay for their children's education

For a college student who doesn't yet have an income, children, or a mortgage, it can be difficult to come up with this estimate. In this case, it may be better to opt for a simpler formula: estimate the likely future salary that will be earned after graduating and multiplying it by 12.

Downsides of Using Life Insurance to Save for College

While life insurance can be a useful tool for covering dependents, there are some significant downsides to using it as a savings vehicle for college. Life insurance policies tend to be much more costly to maintain than other college savings options, such as state-sponsored, tax-advantaged 529 plans. The high costs and difficult withdrawals can hurt families who rely on insurance for college savings.

In addition, the process of withdrawing funds from a life insurance policy can create unexpected hassles, such as income tax on the withdrawn amount and potential penalties if the policyholder is under a certain age. There may also be issues if the policyholder decides to take out a loan against their policy, as policy loans charge interest and require a payback schedule.

Due to these drawbacks, financial experts generally recommend other vehicles for college savings, such as 529 plans, Roth IRAs, or Coverdell Education Savings Accounts.

Protecting parents

Life insurance can be an important component of a family's financial health, especially when it comes to protecting parents. Here are some key considerations for parents when thinking about life insurance in the context of college:

Life insurance can provide financial protection for parents in the unfortunate event of their child's untimely death. If a student passes away prematurely, any debts incurred for their college education, such as loans, still need to be paid off. This can place a significant financial burden on the parents. A term life insurance policy covering the total amount of the expected college debt can help alleviate this burden and ensure that parents are financially protected.

Additionally, life insurance can be beneficial if the student has dependents, such as a spouse or children. In such cases, life insurance can pay off student loans and other debts, as well as funeral expenses. It can also provide financial support for the student's children, ensuring that the family is taken care of even in the absence of the student.

When considering life insurance for college, it's important to keep in mind the potential high costs associated with it. Life insurance policies often come with pricier fees, and the accumulation of value may take multiple years. As a result, it may not be the most efficient way to save for college expenses. Other options, such as 529 plans, offer tax advantages and lower fees, making them more attractive for college savings.

However, life insurance does offer flexibility. It can be used for various expenses, not just qualifying educational costs. Additionally, it is typically excluded from college financial aid formulas, so it won't impact the amount of aid the child may receive.

In conclusion, while life insurance can provide financial protection for parents and ensure that debts are covered in the event of a child's untimely death, it should be carefully considered as part of a comprehensive financial plan that takes into account the specific needs and circumstances of the family.

Frequently asked questions