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Life Insurance for College Savings – Proceed with Caution

As the foliage starts to turn and campus tours bring a new crop of potential applicants to colleges everywhere, anxious parents worry about how to pay for that college degree.  Parents may be pitched the benefits of cash value life insurance as a college savings vehicle.  While the pitch can be enticing and there certainly are benefits to cash value life insurance, you should proceed with caution, do your homework and read the fine print.

Life insurance is an important part of any family’s financial foundation.  It can provide a family with much-needed funds to replace lost income or assets needed to cover outstanding obligations like loans or mortgages. Although insurance is important, there are limits to its usefulness.

Not every tool in a tradesman’s tool kit can be used in every situation. Life insurance for college savings is one of those. I’ve been to many workshops targeted at parents of college-bound high school students and life insurance is touted as a sure thing.  Maybe it’s because I’ve served my time in hell as a mortgage banker for twelve years before putting on my financial advisor hat in 1999 but there are two things that I’m sure of:  There’s no such thing as a simple question and there’s no such thing as a sure thing.

I’ve had friends and clients attend college planning workshops presented by life insurance sales professionals.  And the takeaway: Refinance your home, take cash out and invest in a life insurance policy.  Now at the time, real estate values were only going to the moon so this was a sure thing: low interest rate debt with the added bonus of a tax deduction on the interest and proceeds invested in a tax-free insurance “investment.”

But in the real world, things don’t always work out the way they do in life insurance policy illustrations.

 

  Life insurance comes in many different flavors. The cash value variety includes whole life, universal life and variable life.  Unlike term insurance which provides a set death benefit to your heirs if you die during the policy term, cash value insurance provides coverage for the entire life of the insured. And cash value policies build up that value based on their underlying investments or interest which can be tapped by the insured during life.  Let’s leave the discussion of the particulars of each for another day.  The bottom line for college savings planning is that cash value built up in a life insurance policy is not assessed for the purposes of calculating financial aid.

But the reality is that these policies can be expensive because of the underlying costs – including commissions to agents. Most folks who may use such policies tend to let them lapse because of the high premiums (relative to term insurance or their household cash flow in general).  Or they may decide to not fund them further after their student has graduated from college.  All of this defeats the purpose of getting the policies as a funding vehicle.

Life Insurance as College Funding Source

Life insurance is appealing as a college funding strategy for a number of reasons. In much the same way as a Roth IRA, cash value builds up tax free in a policy and premiums paid into the policy can be withdrawn tax-free without penalty.  And the accumulated cash value in a policy is not a part of financial aid calculations.  This is the big point focused on by college planners.

Unlike the Roth IRA which limits the annual contribution to $5,500, you can put way more into a life insurance contract.  But beware of becoming a Modified Endowment Contract which I discussed in a previous post.

Sure, you can take out cash as a loan from your policy.  Whether or not that is considered in the financial aid calculations is up to the school though.

Low Risk Return

Life insurance can offer a low risk return with a greater sense of security than many other alternatives.  For instance, a whole life policy – while not sexy – can get the job done with few bells and whistles.  Unlike other insurance options, whole life is invested in very boring bonds – investment grade corporates and Treasuries.  The steady and predictable growth of whole life can make such a policy ideal for college funding. Just like the tortoise in the race with the hare, slow and steady may win out in the end.

529 CDs

Most 529 savings plans cannot boast such predictable returns. In fact, through 2010 most plans were pretty flat and account holders had the added kick in the pants from expenses for the underlying funds and the plan itself.  A better 529 option that is a lower cost alternative to life insurance for those who are cost conscious, risk averse or just want to protect a portion of their college savings from market swings would be the offerings of New Jersey-based College Savings Bank which provides 529s in the form of standard and indexed bank CD products.

 The Big Problem with Life Insurance

As I said, every family should have life insurance but for the right reasons. I’m working with a family that has two daughters in high school heading to college. The father is the primary breadwinner while mom works part-time. They have a mortgage and very likely student loans at some point.  And they only have group life insurance offered through his work that would barely cover half of the outstanding mortgage.  These folks clearly have a need for life insurance as part of their financial plan.  Whether or not a whole life cash value plan will be part of the picture will depend on many factors – not just the financial aid calculations.

Because of the way its sold through commissioned agents, cash value life insurance can be very expensive.  To overcome these costs, policies should really be held for the long term.  So if your student is young enough – say more than ten years from going to college – and you also have other needs to protect (who doesn’t if you have a family and a mortgage?) – you should consider this option.

The big problem is that most parents turn their attention to the college funding problem when their children are in high school and they are susceptible to sales pitches. The short time frame makes it difficult to build up enough cash value to make this option really viable and overcome the internal expenses of a policy.  There are better ways.

Lighten Your Load

As with investing, you can take advantage of low-load and no-load insurance options.  At least if you’re using these types of products, you won’t be so far behind the eight ball.  Loaded life insurance policies can be a significant drain on the cash value build up of policies so lightening your load helps you build cash values faster.  And in no load policies, you won’t have to contend with the surrender charges so you’ll have more flexibility with your planning and choice of continuing a policy.

The case for cash value is stronger when you can take some of the costs out of the analysis.  Certainly add life insurance – even permanent or whole life – if you have a need.  But if your children have a couple of years to go until college, you really need to weigh the costs, the lack of transparency in the policy and the impact on your total cash flow to see if this option makes sense for you.

Don’t let a sales pitch sway you.  Do your homework. Working with a fee only financial planner to evaluate your options or to access the growing number of providers offering no load insurance will help you make sense of your options.