How Not to Use Life Insurance to Pay for College

  Here’s a ‘secret’ to all your college funding worries:  Use life insurance to pay for college by hiding your assets, lowering your Expected Family Contribution … and then spend more on college. Say what?!?

Here’s a better tip:  Let me show you how not to use life insurance to pay for college. Like anything else, there’s a right way and a wrong way to use life insurance to pay for college.  Let’s go over the wrong way now.

Parents are always looking to do what’s best for their kids (at least we like to think we are). Paying for college is no different.  And in the words of the great George Foreman in those muffler ads, you don’t want to spend a lot for this … college.  So no one goes out of his way on purpose to spend more on college than they have to but plenty get sucked in to use life insurance which can cost them a bundle.

Life insurance.  Everyone needs it, right?  Sure.  Most of my clients are woefully underinsured for the financial obligations and needs that they have.  But getting life insurance for the wrong reasons is as bad as not having any in the first place.

I’m hearing more and more from parents and colleagues who are hearing the siren call of ‘college planners’ who woo prospects with fantastical tales of how to get more aid and lower their costs.  How?  Well, easy, you use life insurance to ‘hide’ assets.  What they miss telling them is that the parents will likely spend more on college.

With the average cost of a state school with room and board at about $30,000 per year and a private school – not even an Ivy – above $50,000, you can’t blame parents for looking for innovative ways to lower the cost of college.

And life insurance and some annuities are the types of assets which are not reported on the FAFSA, the Free Application for Federal Student Aid college financial aid form used by the vast majority of schools.  For those trying to get into Ivies or certain private and state schools, students will use the CSS Profile form.  But these schools may or may not ask about life insurance cash value.

Pay $40,000 Extra for that Degree

So what’s a parent to do?  Well, hire a ‘college planner’ to help figure this out.  And as a ‘college financial planner’ I’m happy when parents think ahead and bring me on board.  Unfortunately, many parents go to other ‘college planning services’ which are covers for life insurance producers.  Like I said, there’s nothing wrong with life insurance.  There’s a need and they can fill it.  But sometimes a good thing can go too far.

Case in point:  A colleague’s client comes into the office excited with a recommendation from a ‘college planning service’ to use life insurance to remove assets from financial aid consideration.  Since the client has an adjusted gross income over $200,000 per year, they are likely not to qualify for need-based financial aid beyond federal unsubsidized student loans.

But these folks have been diligent savers planning ahead. They have accumulated $264,000 in 529 Savings Plans.  So as part of this recommendation, they’re being told to cash out the 529 Plan, pay the taxes (estimated at over $40,000) and use the proceeds to fund a cash-value life insurance policy.  With an initial contribution of $230,000 to fund the insurance policy, they’ll immediately be able to make this asset bucket ‘invisible’ for financial aid considerations.

Yep, in part that’s true.  That mainly applies to FAFSA schools that don’t look at life insurance cash value. Some CSS Profile schools, too.  But the private schools do reserve the right to ask about other assets – including cash value life insurance.

How do you think that conversation will go over?

Financial Aid Officer to Parent:  So, do you have any life insurance with cash value?

Parent to Financial Aid Officer – hesitantly:  Why? It’s not an asset.

Financial Aid Officer to Parent:  It’s our policy to ask so we have a more complete picture of each family’s resources.  And we see on your tax return that you cashed out your 529 Plan. So where did that money go?

Parent to Financial Aid Officer:  But, but … but

Parent to Self: What did I pay for?  *&#!&@, college planner!

These folks give those of us who know what it means to do holistic, financial planning a bad name.

Nowhere does this ‘planner’ mention that the parent will be required to pay taxes on the 529 Plan distributions. Nowhere is there a mention about the penalty that they will incur for cashing out and using the funds for something other than ‘qualified’ education expenses. Nowhere is there a discussion of how tying these funds up in an insurance policy may put the family in a cash flow bind or, at best, mean that the policyholder has to ‘borrow’ the funds from the policy and a potentially higher interest rate. Nowhere is there any mention that by using lump sum to fund a cash value policy that they’ve created a Modified Endowment Contract or MEC  that makes this no longer a life insurance policy but a nonqualified annuity that is subject to income taxes on withdrawals.  For those interested, I’ve written about the myths of another MEC, the Gerber College Plan here.

So pay taxes now and pay taxes later.  Sounds like such a great deal … for the ‘college planner/life insurance agent’ and his firm since they will walk away with a commission of $10,000 to $20,000 while mom and dad pay $40,000 in taxes on the 529 distribution PLUS what they pay on withdrawals from the MEC later.

Late-Stage College Planning

For late-stage (I call them ‘triage’) clients who come to me with kids who are juniors or seniors in high school, life insurance is NOT going to help them.  It WILL help the insurance salesperson.

The financial aid formulas are mostly driven by INCOME – of the parent and the child.  If there are legitimate ways to reduce income, then the client may benefit for needs-based aid.  This is mostly possible with those who are self-employed or have a Schedule C side business or are investment property owners.

Admittedly, most people are under-insured and there is an argument from a capital needs analysis point of view that the family may need insurance to cover the cost of education or loans incurred. But at this point when a child is about to graduate from high school, the best option is going to be term insurance.  If the ‘college planner’ was talking to parents with infants, then there’s arguably more time for cash value life insurance to make sense.

But moving money from a 529 account to incur tax costs to fund a MEC that also has tax costs, is courting a malpractice suit, IMHO.

If the student were looking at a school using the CSS Profile which counts home equity, then you could possibly make the argument that using home equity to fund the insurance policy could shelter some assets from being assessed.  But most schools using the CSS Profile cap how much home equity they consider, so the value of this is very limited.

BTW, merit-aid is based on merit not the financial profile of the student.  And many Ivies (which use the CSS Profile) don’t even give merit aid. So the “college planner’s” advice here is dubious at best.