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Thinking outside the box for college funding….529 plans are not the only alternative

Financial Empowerment

One alternative to a 529 account for college funding is to use a life insurance savings plan, which is a properly structured life insurance contract built for cash accumulation. We believe the life insurance savings plan should not be overlooked when exploring college funding alternatives because it does not have the restrictions of the 529, yet it still has similar tax benefits, if utilized correctly (i.e., tax-deferred growth, tax-free access to cash).    

 This article will outline for the discerning grantor that a life insurance savings plan will likely cost a little more, but will have more predictable returns (downside protection), and will have more flexibility in use (if a recipient, i.e. child/grandchild, does not go the traditional school route).  Of course, for some the simplest approach is to stick with the 529's because it is a vehicle you are probably familiar with, but if flexibility and downside risk protection are important, using life insurance should be given serious consideration. 


SUMMARY OF PROS AND CONS OF ALTERNATIVES

529 ACCOUNTS

In many ways, money invested in a 529 account functions much the same as a Roth IRA.  Money invested in the account is after-tax dollars, meaning there is no deduction for money contributed into the account.  Money in the account grows tax-deferred and is available for withdrawal on a tax-free basis when used for “qualified higher education expenses.” 

1. What are Qualified Higher Education Expenses?

Very generally, “qualified higher education expenses” include such thing as tuition and fees for a “qualified institution,” room and board (subject to limitations), and required books and required equipment.  Most accredited universities are “qualified institutions,” but there are many educational options that are not.

2. What if Money is not Used for Qualified Purposes?

If money is not used for “qualified” expenses, the earnings portion is subject to income tax, plus a 10% penalty tax. This penalty can be avoided:

  • If a recipient receives a scholarship, dollars equal to the scholarship can be withdrawn from the 529 without the 10% penalty, but income tax will still have to be paid on the earnings. Or,
  • The funds could be transferred to another family member and used for their education and qualified expenses.  This seems a cold comfort – the recipient who does not go a traditional college route receives no assistance, and the money will only avoid penalty if one of the other qualified recipients needs more money for educational purposes. 

Clearly there is not a lot of flexibility in these types of accounts and there is real risk due to uncertainty.

3. The Risk of Uncertainty:  Individual and Systemic

Uncertainty is the main reason one should be cautious about 529 accounts. As it is, there is a fair degree of uncertainty at two levels (a) individual uncertainty (e.g., will the recipient go the traditional college route), and (b) systemic uncertainty (if they do go to college, will their chosen institution be deemed a qualified institution).

 In either of these instances, you are faced with the uncomfortable position of paying some hefty taxes on gains in the 529 accounts, or scrambling to redistribute the money to other members of the family. Ultimately the tax penalty would be saved but this would leave the intended recipient without the financial assistance the other family members received. 


Summary of Pros and Cons of 529 Accounts


Pros:

  • Tax-deferred growth.
  • No Federal income tax is owed on money if used for “qualified higher education expenses.”
  • Relatively low-cost.
  • Relatively simple.
  • Investments in the stock market have potential to deliver high returns.
  • Can front-load contributions (up to five years of annual exclusion equivalent).
  • Removed from estate, yet you maintain control.   

Cons:

  • Governmental control over use of the money.
  • Record keeping requirements and pitfalls.
  • Potential for taxes and penalties.
  • Investments in the stock market have potential to lose substantial value.
  • Will have a somewhat negative impact on financial aid considerations.


LIFE INSURANCE SAVINGS VEHICLE

Please note that these are purely hypothetical numbers for the purpose of illustrating concepts. 

Life Insurance Structured for Accumulation

Most often, life insurance is structured to deliver the maximum death benefit for the lowest premium.  Let’s say, $100,000 of life insurance coverage costs $1,000 per year.  That is the minimum amount the purchaser must pay to get that coverage, but the insurance company is willing to let the purchaser “overfund” the policy.  This basically means the purchaser puts more money into the policy than required in order to take advantage of the tax benefits that the tax code grants to insurance policies – namely, tax-deferred growth, tax-free death benefit, and tax-free access to cash value.[1]  The excess payment increases the policy’s “cash value.”  Additionally, the insurance company will agree to credit interest (subject to limitations) to the cash value, which further grows cash value. For example, if the same person decides to pay $20,000 rather than $1,000, then after year 1, they will have cash value of $19,000.  In addition, if the insurance company has agreed to credit interest at the rate of 5%, this would increase cash value by another $950.  

Well, why not buy $1 worth of insurance coverage and make $19,999 cash value?  That would be brilliant.  However, this would be a gigantic tax loophole through which the shrewd minds would quickly run through.  Thankfully, Congress’s response was not to eliminate the tax benefits, but to take a middle road by putting limitations on maximum amounts that can be put into a life insurance contract, relative to the death benefit.  So, if there is a $100,000 death benefit, the IRS may say the maximum amount of cash that can be paid in is $15,000, but if the death benefit is $1,000,000, you can pay in up to $100,000.  These are just examples and it is more complicated than that, but this is essentially how it works.  In designing a policy for accumulation, we always want to fund right up to the maximum the IRS allows, without going over.  This maximizes efficiency of the policy by minimizing insurance costs, and increases the cash value that grows tax-deferred and provides tax-free resources when needed.

 

Disadvantages Compared to 529

Since this is an insurance policy, there are obviously insurance charges associated, which will put some drag on performance, especially in early years.  As compared to taxable accounts, the tax savings of life insurance typically far exceed the costs of insurance.  But, generally speaking, the 529 account and life insurance have similar tax characteristics:  tax-deferred growth, and tax-free access to value.  Therefore, as compared to a 529, the insurance will likely be more expensive because the tax savings are essentially the same.  If the money is used for qualified expenses and the stock market cooperates, the 529 will most likely have more money after 10 years.  If the stock market does not cooperate or the recipient does not go the traditional education route, the benefit of the insurance-based plan will likely substantially exceed the additional costs. 

It is also important to appreciate that insurance costs are front-loaded, whereas investment costs are spread out over the life of the vehicle.  Therefore, insurance will cost more in early years, but this will reduce substantially in later years.  Please keep in mind, if life insurance is used, it is important to remember this is a long-term vehicle where early acquisition costs pay off later on.  Think of it like buying a piece of equipment:  you can buy Machine A that costs $100 in year 1 and $1 per year to maintain, or Machine B that costs $10 per year for as long as you have it.  Which is better?  Well, if you are only going to use it for 5 years, Machine B is better.  But as the years go on, you are better off having paid more upfront.  So, when we utilize insurance, we assess performance on five-year intervals, rather than annually as done in investment accounts because we recognize there is an acquisition cost.

Primary Advantage:  Flexibility

There are no governmental restrictions on use of the money.  In this way, the government’s ability to manipulate decisions is lessened.  Your recipients will have more freedom to make decisions about the best educational path specifically for them, without worrying about whether a particular path is approved by the Federal government.  All this while being able to access the money on a tax-free basis by withdrawing basis and then borrowing against the policy (these loans are available on a no-cost basis from most carriers)[2]

Another factor adding to flexibility is you do not have to keep meticulous records to prove the money was used for approved expenses, easing the burden on everyone and removing potential pitfalls.

Advantage:  Crediting Methodology

There are various options as to how interest is credited on life insurance cash value.  The policy holder could choose to invest cash value into various subaccounts, which are essentially mutual funds that own securities and can go up and down like the stock market.  This type of policy is called “Variable Universal Life.”  They have more potential for upside, but also have the potential to drop as the markets fluctuate.  If the market drops by 30%, your cash value drops by 30%. This functions much like a 529 would.

A steadier interest crediting methodology is indexing.  This approach tracks a particular index, such as the S&P 500 index, and credits interest that correlates to the performance of the index, subject to a cap and floor. 

  • For instance, if the S&P is up 10% at the end of the first year, your cash value is credited interest of 10%. 
  • On the other hand, if the S&P drops by 30%, your cash value does not decrease by this amount, rather you just get no interest credit that year, and you start over the next year (as mentioned above, there are still insurance charges for the insurance coverage, but there will be no drop due to performance). 
  • In exchange for the floor, there is a cap on interest crediting.  For example, let’s say the cap is 11%.  If the S&P goes up 20%, you will hit the cap and your cash value will be credited interest for the year at a rate of 11%.  Caps are subject to change by the insurance company, though they are very reluctant to do so.

This type of policy is called an Index Universal Life policy.  You see that there is ability to capture some upside while limiting downside risk, which provides more steady returns.  An even more conservative option is available to fix the crediting interest rate at 3.5% to 4%.  This is the steadiest approach, but, historically speaking, the indexing methodology returns better on average. 

The bottom line is that the indexing methodology is not available in a 529 account.  In a 529, you are invested in mutual funds essentially, which can be great if the market cooperates, but can be painful if we get 2008 performance right before college years begin for a recipient.  

Summary Comparison: Most definitely there is another alternative for college funding



Factors
529 Account
Accumulation Life Insurance
Tax-Deferred Growth
           Yes             Yes
Tax-Free Access to Money
           Yes             Yes
Government Restrictions on Use of Money
           Yes             No
Cost Considerations
Likely lower cost  Likely higher cost
Downside protection
           No            Yes
High upside potential
          YesNo, upside capped
Simple to Implement
          YesSome complexities to work through
Impact on Financial Aid
   Slight impactPotentially no impact if utilized properly

 

Notes:

[1] Cash value can be accessed as by borrowing from the insurance company, so long as the policy is properly structured and funded.  

[2] Loans and partial withdrawals will decrease the death benefit and cash value and may be subject to policy limitations and income tax, which includes the possibility of contract lapse.

  


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