Over the past few weeks I have been asked (and pitched) the idea of whether cash-value life insurance makes sense as a vehicle for saving and paying for college. By cash-value life insurance, I am including whole life, variable life, universal life and variable universal life policies.
First, in almost all cases, it does not. The very few cases where it may make sense will be covered shortly.
Here are some reasons why a 529 college savings plan is better than cash-value life insurance.
- 529 plans have very high contribution amounts. Depending on your state, the total amount you can contribute to your 529 plan is very high, and the annual contribution amounts are high as well.
- From a federal tax perspective, you are allowed to contribute up to $14,000 annually without incurring gift tax consequences. This amount doubles to $28,000 annually if you’re married and elect to split the contribution.
- The law also allows a 5-year pro-rata contribution to the plan. In other words, an individual can contribute up to $70,000 in one year and not incur gift tax consequences (up to $140,000 if married). Thus, five years’ worth of contributions can be made in one year. This allows a significant contribution in one year, as well as estate reduction at the same time (Note: if the maximum pro-rata contribution is made, more contributions are not allowed until after 5 years are up).
- Life insurance, if over-funded, loses its favorable tax treatment of cash withdrawals and loans.
- 529 contributions may be state tax-deductible. Many states that offer 529 plans allow tax deductions in the amounts contributed to the plan. Some states allow up to a $14,000 deduction per beneficiary ($28,000 if married filing jointly) per year. Here in IL, the deduction is $10,000 per beneficiary ($20,000 in married filing jointly). Personal life insurance premiums are not tax deductible.
- Qualified 529 withdrawals are tax-free. Generally, a qualified withdrawal covers tuition, fees, books, supplies, and eligible room and board costs. Life insurance withdrawals and loans are also tax-free (provided the policy still meets the definition of a life insurance contract). If not, withdrawals and loans are taxed at your ordinary income rates.
- 529 plans do not have “insurance drag”. Life insurance is just that – insurance. Thus, the contract will have mortality and expense charges which are the charges to administer the policy and the costs to insure the insured. These will lower the potential returns that would otherwise be received in a 529 (hence the term “insurance drag”). Additionally, most cash-value life insurance policies carry stiff and lengthy surrender charges/periods. Surrender charges are used to cover the “acquisition” costs of the policy (which are generally the high commissions paid to the salesperson). Cancel the policy early, and you’ll receive much less than the cash value. Plus, in most cases (unless funded correctly and specifically), the cash value takes a long time to build, and you do not have access to all of the cash value like you would in a 529.
Now, here are some rare examples where cash-value life insurance may make sense. Again, these are rare and in most cases, do not apply to most individuals or families. In other words, if you’re a life insurance salesperson, do not use these as a reason to make your sale! If you’re an individual or family and you think you may be in this situation, contact us and we will refer you to a qualified, fiduciary, fee-only life insurance actuary.
- There is a need for life insurance – in both accumulation and after education expenses are paid.
- Since saving for college is a relatively short-term goal, some individuals may have a very conservative savings approach. Life insurance may provide some stability in returns (if using a non-variable policy such as ordinary whole life or universal life).
- Additional savings for private elementary and secondary schooling. High net worth and ultra-high net worth individuals who send their children to private schools may have a need for additional savings strategies above (or in lieu of) those provided by Coverdell ESAs.
- You can afford it. Cash-value life insurance is not cheap. Additionally, many policies such as ordinary whole life offer zero flexibility in premium payments. Also, the policy needs to be set up where the premiums are not only affordable, but offer the greatest probability of funding the policy correctly so the cash value grows considerably, above and beyond the costs of insurance.
- You (or for whomever the policy is underwritten) are insurable. This means you must qualify for the life insurance. There’s a chance you may be denied coverage (medical history, current disease or illness), in which case life insurance isn’t an option. And even if coverage is allowed, there’s always the possibility of being rated at substandard level; meaning, you are insurable, but the costs are going to be much higher than normal.
Another point – a 529 plan has no income restrictions. This means that regardless of your income, you are not limited in contributing to a 529 plan. The same is true with life insurance.
If you’re considering a 529 or cash-value life insurance for education savings, feel free to contact our offices for a second, third, or multiple opinion.
Special thanks to Scott Witt of Witt Actuarial Services, LLC for his help on this post.