MAY 07, 2008 | BY ROCCY DEFRANCESCO
Paying for a child’s or a grandchild’s college education has become increasingly difficult as the costs of college continue to increase. I am amazed at what it costs to attend college now.
Today, Section 529 plans seem to be the tool of choice to pre-fund and build a tax-favorable pool of money for college education. I put together my own brief list of the pros and cons of 529 plans:
Pros of 529 Plans
- Once the plan is funded (after-tax), the money can grow tax-free and be removed tax-free for qualifying college education expenses.
- If owned by the parent(s) or grandparent(s), and funded correctly, the plan’s assets (including growth) are out of their estate for estate tax purposes.
- If the plan is owned by the parent(s) or grandparent(s), and if the child or grandchild does not go to college, the money can be used by the owner(s) for other purposes and would act like an IRA (with similar income taxes and penalties).
Cons of 529 Plans
- If the child does not go to college, the growth on the money becomes taxable and subject to potential penalties when withdrawn or otherwise used by the parent(s) or grandparent(s).
- The money in a 529 plan is subject to loss due to market risk.
- 529 plans are not “self completing,” should a parent or grandparent die prior to complete funding.
- 529 plans have funding limits. Funding is limited by the $12,000 annual gift tax exclusion (although they can be super-funded in year one by pouring in the first five years’ worth of gifts all at once, totaling $60,000).
Using Permanent Life Insurance as an Alternative Funding Vehicle
Why would anyone use permanent life insurance (universal life or whole life) as a funding vehicle to pay for college education? There are several good reasons. (I’ll assume that the life insurance policy will be written on one of the parents.)
- Life insurance is a “self-completing” plan. Let’s assume dad is the breadwinner in the family. If he dies when a child is young without fully funding a 529 plan, there will be a significant shortfall when the child goes to college. But if dad owns life insurance, it would pay an income tax-free death benefit to the beneficiary (presumably the surviving spouse) who can use that money for the child’s college education.
- Cash value in a life policy will not only grow tax-deferred, but can be removed tax-free (within limits) for college expenses, through policy loans.
- After borrowing from the policy, it will still have cash value that can grow for years to come. When the parent is in retirement, he or she can access that cash through withdrawals and policy loans. A 529 plan does not allow this.
- Money in a permanent policy is not a countable asset when a child applies for college financial aid.
Comparing the Two Approaches in Dollars
I was curious to find out whether life insurance can outperform a 529 plan for generating cash to apply to college expenses, using real-world math and reasonable rates of return. I ran the numbers for myself, using my favorite cash-building policy, an indexed universal life product. I was surprised at how the numbers turned out. The 529 plan did surprisingly well, although there are scenarios in which the life policy can outperform the savings plan.
For my example, I used a 30-year-old father with a 6-year-old child who will go to college at age 19 and be there for five years. Dad pays a $3,500 premium each year into the life insurance policy until the child turns 18. I assumed a 7.5% rate of return in the life policy, with “wash” loans, i.e. the policy loan interest rate and the cash value crediting rate are the same. For the 529 plan, I assumed a 1.2% mutual fund expense load.
How much could dad remove from his life insurance policy each year during the child’s college years (ages 19-23)? $12,330.
How much could be removed from a 529 plan? $16,125 per year.
What if we change the policy to have a 1% positive loan spread? That increases the cash total only by a few hundred dollars, to $12,696. A 2% positive spread raises it marginally again to $12,974, still almost $3,200 behind the 529 plan.
It’s important, however, to look beyond the raw numbers and beyond the college expense years. When you do, the life insurance advantages become clear. With wash loans during the college payout years, the policy would still have $64,000 of cash value when dad turns 70. That amount soars to $142,000 with a 1% loan spread and $209,000 with a 2% loan spread.
In addition, the death benefit at age 70 would be $280,000. Neither the cash-accumulation opportunity after the college years, nor the net death benefit in force at all times, are available through the 529 plan.
The college payout improves for the life insurance if more premiums are paid in the first five years of the policy (if it is overfunded early), but it still falls short of the 529 payout. However, if you keep everything the same in the previous example, except to lower the insured father’s age from 30 to 24 and the child’s age from 6 to zero (newborn), the results change dramatically. The 529 plan will produce an annual payout of $29,051, but the life policy with wash loans will top that with a payout of $30,784 per year.
Taking the Long-Term View
Purely from the standpoint of college savings, using permanent life insurance is difficult to justify over 529 plans for most clients unless you weigh the additional lifetime advantages of the life coverage. Self-completion, locked-in investment gains, tax-favored access to cash throughout the owner’s life, and exemption from countable assets are significant values to the client.
Also, the client may choose to have his children take out student loans to pay for college, knowing that the interest rate is very low and that the money in the life policy will grow at a better rate. This provides leverage and options for the parent, and the ability to give more money to the child tax-free later on, to pay off the student loans and then some.
The best service you can provide your clients as they plan for the college-expense years is to know the advantages and disadvantages of all the options and help them plan for those crucial years with a long-term perspective. Success in those efforts may find you serving that younger generation as well, when they are grown up and starting families of their own.
Roccy DeFrancesco, JD, CWPP, CAPP, MMB, is the founder of The Wealth Preservation Institute and a co-founder of the Asset Protection Society. He is licensed to practice law in Indiana and Michigan and serves on the Law Practice Management Committee of the Indiana Bar Association. He is a frequent contributor to medical, accounting, and financial journals and has lectured before numerous regional and national professional organizations.
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