Life Insurance For Students: Is Cash Value A Good Option?

The high cost of college education often prompts parents to consider different methods to save for their children's future. One option is to take out a permanent life insurance policy, which, unlike term life coverage, has a tax-deferred savings component. The cash value of a permanent life insurance policy can be used to pay for college expenses. However, there are pros and cons to using life insurance as a college savings vehicle.

Pros of cash value life insurance for college savings

Cash value life insurance can be a good option for college savings, offering several advantages over other savings vehicles.

Flexibility

Compared to other savings options, such as 529 plans, cash value life insurance offers greater flexibility. 529 plans can only be used for qualifying educational expenses, whereas the cash value of a whole life insurance policy is not limited to specific types of expenses, giving policyholders more control over how they use their money. This flexibility can be especially useful if your child decides not to pursue a college education, as you won't be penalised for withdrawing funds from a life insurance policy in the same way you would be with a 529 plan.

Exclusion from Financial Aid Calculations

Money saved in a 529 plan is considered a parental asset and can reduce the amount of financial aid your child is eligible for. On the other hand, cash value life insurance is typically excluded from these calculations, meaning it won't detract from any aid your child could receive.

Tax Benefits

The cash value of a whole life insurance policy grows tax-deferred over time. Withdrawals are generally tax-free up to the amount of premiums you've already paid. Beyond that, the money is taxable, but this may not matter since educational expenses, except for room and board, are tax-deductible.

Access to Dividends

As a whole life policy owner, you may be eligible to receive dividends, which can be received as cash or used to purchase additional insurance, potentially delivering even more dividends over time.

Protection for Your Child's Future

By purchasing a life insurance policy for your child at a young age, you can lock in protection for the rest of their life at a lower cost. This can be a good way to offset some of their future expenses, including college costs.

Cons of cash value life insurance for college savings

While cash value life insurance can be used as a college savings vehicle, there are some drawbacks to this approach. One significant disadvantage is the high cost associated with these policies. The fees for permanent life insurance can be much higher than those for other investment options, such as 529 plans. Upfront and recurring fees, including commissions for insurance representatives, can eat into the money that would otherwise be invested and growing in value.

Another issue is the time it takes for the cash value to accumulate. It can take 10 years or more for the cash value of the policy to surpass the amount paid in premiums, making it challenging to build up assets in time for college tuition bills. The annual expenses and investment costs associated with permanent life insurance policies can further weigh down earnings.

Withdrawing money from a life insurance policy can also be more complicated than with other savings vehicles. Parents may have to pay income tax on withdrawals, and there could be a penalty if they are under a certain age. Taking out a loan against the policy can help avoid these taxes, but it still accrues interest and requires a payback schedule. If the loan isn't repaid, the death benefit will be reduced.

Additionally, insurance agents may not always have the client's best interests in mind when structuring policies. They often earn commissions based on target premiums, leading to policies with higher death benefits and higher premiums that may not be necessary for families saving for college. As a result, the cash accumulation in the policy may be lower than expected due to higher premium payments.

How permanent life insurance works as a college savings vehicle

Permanent life insurance is a possibility for funding a child's education, as many insurance agents will be eager to tell you. It offers a greater degree of flexibility than a 529 plan, but this comes at the cost of pricier fees.

Here's how permanent life insurance works as a college savings vehicle:

How Permanent Life Insurance Works

For every dollar you pay in premiums, a portion goes towards the death benefit, while a separate portion is diverted to a separate cash-value account. Whole life insurance is generally the safest kind of permanent life insurance. The issuer credits your account with a guaranteed amount, and most policyholders can expect a return of 3-6% after the first several years. The money in the cash-value account grows tax-deferred, much like a 529 plan.

Other types of permanent life coverage, such as variable life insurance, give policyholders a degree of control over their investment. In this case, you select the sub-accounts (essentially mutual funds) that you want to be attached to your policy, and your account's annual return is pegged to the performance of these underlying investments. The potential reward is greater, but there's a risk that your balance could fall if the market takes a plunge.

Using Permanent Life Insurance for College

When it's time for your child to start college, you can take out a loan against your cash balance. The insurer will reduce your death benefit if you don't pay back the loan, but that's not necessarily a drawback if you intended the policy to be a college savings plan.

Pros of Using Permanent Life Insurance for College

When contrasted with a 529 plan, permanent life insurance offers flexibility. If your child decides against going to college, any earnings in your 529 account will be subject to ordinary income tax rates and a 10% tax penalty if you decide to withdraw them. By contrast, you have the option to use the money in your permanent life insurance policy for anything you want. It's also not included in financial aid calculations, whereas up to 5.64% of parental assets in a 529 plan are counted in the applicant's Student Aid Index for each year of college.

Cons of Using Permanent Life Insurance for College

Permanent life insurance has some less attractive features, such as upfront and recurring fees. For example, 50% or more of your first-year premiums will typically go towards paying the insurance representative's commission. It can take 10 years or more for your cash value to surpass what you'll pay in premiums, so it's hard to make a case for permanent life insurance as a way to build up your assets in time to pay tuition bills. On top of that, heavy annual expenses will continue to weigh down your earnings. Most permanent life insurance policies charge upwards of 2% per year in administrative and investment costs.

Whole life insurance as a college savings vehicle

Whole life insurance is a type of permanent life insurance that provides a death benefit and can build cash value. Part of each premium payment goes towards the life insurance, and another portion goes towards building cash value with tax efficiency. The earlier you take out a whole life policy, the more affordable the premium tends to be, and this premium never changes. Over time, the policy can build up a meaningful amount of cash value.

Whole Life Insurance vs 529 Plans

A 529 plan is a popular way to save for a child's education, offering tax benefits and investment options. However, it is subject to investment and market risks, and any funds not used for qualifying educational expenses may incur penalties. In contrast, the cash value of a whole life insurance policy is more flexible and can be used for any expense without penalty. It is also typically excluded from college financial aid formulas.

Using Whole Life Insurance for College Savings

There are several ways to use whole life insurance as a college savings vehicle:

• Withdraw some of the cash value to pay for educational expenses. This is generally tax-free up to the amount of premiums paid.
• Take out a loan against the value of the policy. This option is also tax-free and does not require a loan application process. However, it is important to note that the insurer will reduce the death benefit if the loan is not repaid.
• Use the cash value of a policy taken out on your child. Insuring your child at a young age locks in lower insurance costs, and the policy can accumulate value that can be accessed to offset college expenses.

Considerations

While whole life insurance offers flexibility, it also has some drawbacks. It tends to have high upfront and recurring fees, and it can take 10 years or more for the cash value to surpass the amount paid in premiums. Therefore, it is essential to carefully consider the costs and potential benefits before choosing whole life insurance as a college savings vehicle.

Universal life insurance as a college savings vehicle

Universal life insurance is a type of permanent life insurance that can be used as a college savings vehicle. While it may not be the first thing you think of when it comes to saving for college, it can be a useful tool when combined with other savings options. Here are some things to consider when thinking about universal life insurance as a college savings vehicle:

Flexibility

Universal life insurance offers more flexibility compared to other savings vehicles like 529 plans. The cash value of a universal life insurance policy is not limited to specific types of expenses, giving you more control over how you use the money. It can be used for college expenses or other financial needs. Additionally, it is typically excluded from college financial aid formulas, so it won't reduce any financial aid your child may be eligible for.

Tax Advantages

Universal life insurance has tax advantages that can benefit your savings strategy. The cash value of the policy grows tax-deferred, and distributions can be taken in a tax-free manner. Withdrawals up to the amount of premiums paid are generally tax-free, and educational expenses, except for room and board, are tax-deductible.

Limited Downside Risk

With universal life insurance, you have a death benefit and a cash value account. The cash value can earn interest based on the performance of an underlying index, such as the S&P 500. If the index performs poorly, you may receive less interest, but your cash value won't decrease due to poor index performance. This provides upside potential with limited downside risk.

Financial Aid Benefits

When saving for college, it's important to consider how your assets will impact financial aid calculations. Life insurance is not included in financial aid analysis, so using universal life insurance as a college savings vehicle won't reduce your expected family contribution. This is unlike other savings vehicles, such as 529 plans, which are factored into financial aid calculations.

Loan Options

Universal life insurance allows you to take out a loan against the value of the policy. This can be a convenient way to access funds for college expenses. The loan distribution is generally tax-free, and there is no separate loan application process. However, it's important to remember that if you don't pay back the loan, the outstanding balance will likely be deducted from the death benefit.

Long-Term Planning

Universal life insurance can be more than just a college savings vehicle. After your child finishes their education, you can continue funding the policy and use it as a source of retirement funding in the future. This dual purpose makes it a versatile tool in your financial planning.

In conclusion, universal life insurance can be a valuable component of a well-rounded college savings plan. It offers flexibility, tax advantages, and limited downside risk. However, it's important to carefully consider the fees and charges associated with these policies and seek advice from a financial professional to determine if this option aligns with your specific goals and circumstances.

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