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.
Sterling Raskie is the author of this article. He received insight from Scott Witt of Witt Actuarial Services, LLC.
Sterling Raskie, MSFS, CFP®, ChFC®
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About half of what you said about life insurance is semi-correct, the other half is garbage and the person you asked for help on the post, Scott Witt, an insurance professional? should know more about life insurance. Let me start by saying, I’m not rich or ultra rich, but I did learn about using life insurance as a college funding vehicle several years ago and am currently using it to put my two sons through college.
I could list twenty things incorrect, but here are a few.
You say 529 have very high contribution amounts. Not as high as the 50K Ive been able to add to my life insurance policies each year. A life insurance contract can hold a lot of money. And if you run out of room in your policy, insure your spouse or children. A 529 can’t hold as much as an insurance policy when properly designed.
You say overfunding life insurance will cause it to lose it’s tax favored status. That’s why you work with an agent that designs a policy to be as close to the max premium level without losing the favorable tax status.
You say you must be insurable. You can insure your spouse or children and use the insurance policy to fund any one of the children’s college education.
You say insurance premiums are not flexible. A correctly designed policy has a ton of funding flexibility. I can go from 400/month to 2500/month.
My cash value didn’t take long to build, it was there after my first premium payment and has been growing risk free ever since. And you are correct, I don’t have access to ALL of my cash value, just 90% of it, which is fine with me.
You say life insurance is full of fees. Sure, the 529 plans don’t contain fees and expenses?
529s can’t pay for a college commuting car, a semester off or abroad, or non college tuition/room/board.
529’s are tax free, sure so it’s my life insurance withdrawals or loans.
529s contain risk, whole life insurance contains no risk so you know exactly how much you will have in the account at the exact time you need it. With a 529 plan, you make take a market loss and never get back to break even.
529s don’t “self complete.” If I pass away, my life insurance “self completes” and provides an instant fully funded college account.
None of the reasons you stated as examples of when to use life insurance are “rare.” 90 percent of the folks I talk to have no insurance or are underinsured. I’ve seen one substandard policy in 5 years. I’m not rich or ultra rich, I just studied life insurance as a financial vehicle and I”m glad I wasn’t lured into a 529 for my families college funding.
I could go on and on, but I’m shocked this article was written by an insurance professional and he couldn’t accurately compare an insurance policy with a 529 plan.
Hi Bob,
Thank you for your candor. Let me reply by line item to your comments.
529 contribution limits are very high. This is not incorrect. Additionally, a married couple can fund a single 529 with $28,000 annually (with a potential state tax deduction), which over 15 years, is $420,000 (some state caps will apply) for college (not including growth/interest). They can do the same per child. So, 2 children would allow $56,000 annually – total over 15 years = $840,000. I’m not sure why you’d need a life policy to hold more.
Improperly over-funding will cause a life policy to lose tax-favored status. This is not incorrect. Proper policy design is necessary to avoid MEC status. I mentioned this in the article.
Regardless of who has the insurance, the insured must be insurable. This is not incorrect. 529s require no underwriting.
The article mentions ordinary whole life insurance offers no premium flexibility. This is not incorrect. UL and VUL offer premium flexibility. Perhaps this is what you are referring to.
Cash value does take time to build. Unless someone over-funds the policy correctly right away (as mentioned in the article). Most people do not, and are unaware of how/why to do this. Most sales people don’t know either.
Many 529 plans offer very inexpensive funds. For example, I pay about 3 to 4 basis points for my fund holdings. Much cheaper than M&E in a life policy. Plus, I get the state tax deduction.
529s are for college expenses. They aren’t savings vehicles for non-college items like travel, vehicles, etc., and were never meant to be. Neither was life insurance. A job can just as easily pay for a semester off.
Qualified 529 withdrawals are tax-free. This is not incorrect. So are life policy loans and withdrawals. The article mentioned this. You simply restated it.
Yes, 529s may carry investment risk. Hence the article mentioning one of the rare instances where it may make sense for a very conservative person; assuming they can afford it, are insurable, and can find a professional qualified to design the policy. Or they may consider a 529, invest it in a money market fund (no risk), and still get the tax advantages.
Term insurance does the same thing, for much less. However, the death benefit should include college funding (as well as income replacement, retirement, etc.).
It sounds like you sell life insurance. When all you have is a hammer….
Again, thank you for your comments.