Should you pay for college with a life insurance policy?
When it comes to paying for college, many parents find themselves overwhelmed by rising tuition costs and uncertainty about the best way to save.
While many financial experts tout 529 education savings plans, or state-sponsored, tax-advantaged accounts as the best way to save for college, some insurers and financial planners are promoting cash-value life insurance policies as another way to pay for a child's college education.
What's the difference between a 529 plan and life insurance?
There are two types of 529 plans: prepaid and savings plans. The advantage of these plans is that earnings aren't taxed if the funds are used to pay for qualified college expenses.
With life insurance, parents purchase a cash value policy that can pay for a child's college education in the event that the family's primary breadwinner dies prematurely. However, death isn't the only way to use a cash-value life insurance payout: This policy accumulates cash value on a tax-deferred basis. These funds can then be accessed as a tax-free loan or withdrawal when it comes time to pay your child's college tuition costs.
A survey released in April 2014 by Sallie Mae, the nation's largest private-student loan lender, showed that 19 percent of families saving for college plan to use life insurance policies to pay for college costs.
But should you buy a life insurance policy to pay for college funds?
That depends on a variety of factors including the child's age when you begin college planning and your family income, says Tracy Tamura, a life insurance agent and mother of three who owns Tamura Insurance in Pleasant Hill, Calif.
"Using life insurance as a college funding tool isn't the best option for everyone," says Tamura, who leads workshops on how families can pay for college. "I let (clients) know the advantages and disadvantages of the various savings options and help them design a savings plan based on their individual needs."
How life insurance can pay for a college education
While the primary purpose of life insurance is to provide a death benefit to beneficiaries, it can also be used to help fund a college education.
Life insurance policies that carry a cash balance allow consumers to withdraw up to the amount paid in premiums tax-free or to take out a policy loan to cover the costs of a college education.
However, since policy charges and fees can be high on some of these life insurance policies, it's important for families to talk to their insurance agent or a financial planner to ensure the return of a life insurance policy will outweigh the costs.
Pros and cons of using a cash-value life insurance policy for college costs
We asked Tamura and Kalman Chany, author of "Paying for College Without Going Broke" and founder and president of Campus Consultants, a New York-based firm that helps families get financial aid, for tips of purchasing a cash-value life insurance policy to help pay college costs.
Pro: Good option for parents who plan far in advance.
"Purchasing a life insurance policy to pay for a child's college tuition makes the most sense for families with children under the age of 3, since it may take as long as 10 years to contribute enough to overcome expenses and maximize cash value," Tamura says. Expenses include monthly premiums and an agent's commission fee on the insurance policy.
Pro: Life insurance can be used for other expenses.
"Let's say that your child excels in academics and sports and lands a fully paid scholarship to the university of their choice," Tamura says. "With a life insurance policy, students don't just have to use the money for college. They could use it to pay for a down payment on a house or in whatever way they wanted."
According to the Internal Revenue Service, money in a 529 college savings plan can only be used for college expenses, so if your child gets a scholarship or decides not to go to college, your only options are to transfer 529 funds to another beneficiary, or take the funds out of the account and pay interest on the withdrawal."
Con: Not the only way to save on taxes. "Many people believe that purchasing a cash-value life insurance policy to fund their child's education is the only way to accumulate cash on a tax-deferred basis," Chany says. However, earnings in 529 accounts aren't federally taxed and withdrawals for qualified higher-education expenses are free from federal tax.
"Some states also allow for a deduction against contributions," Chany adds.
Pro: Less risk, more control.
In the wake of the economic downturn, many families are looking for safe ways to invest. Cash value life insurance policies have predictable returns whereas 529 plans rely on the performance of the investments in their funds. "Since these life insurance policies usually offer a low return the first few years, it's important to look at the child's age when you buy a policy, how much you money you plan to contribute to the policy, and how much college will cost when your child is ready to attend," Tamura says.