Using Life Insurance for College Savings? Proceed With Caution

For many families, any discussion about saving for college starts and ends with 529 college-savings plans, tax-advantaged accounts designed for just that purpose. But in some cases families are using a less well-known, and somewhat controversial, approach: cash-value life insurance.

The subject of cash-value life insurance--which includes whole, universal, and variable life--in itself can elicit strong opinions. Critics decry its higher cost--and high commissions paid to salespeople--compared with less expensive term insurance, which pays a death benefit when the policyholder dies but which offers no cash-value benefit and is only good for a fixed time period. Cash-value policies, on the other hand, are good for the life of the policyholder and include a cash-value feature that consists of a portion of the premiums paid on the policy along with interest accrued and, in some cases, investment gains or losses. The policyholder can withdraw funds from this cash value--which has the effect of reducing the death benefit of the policy by the amount withdrawn--or take a loan from the insurance company, using the cash value as collateral and paying interest on the loan.

It's this ability to tap the cash value of such life insurance policies that makes them viable as a college-savings option, but their appeal lies largely in the fact that they also afford tax and financial-aid advantages. The cash value of the policy grows tax-free, and the portion of the cash value made up of premiums--in other words, not including interest or gains--may be withdrawn tax-free and without penalty. Another advantage is that cash-value life insurance is not counted as an available asset in financial-aid calculations. So a family could conceivably put tens of thousands of dollars into a policy's cash value without it hurting a student's financial-aid prospects. However, money withdrawn from the cash-value part of the policy is treated as a form of income and does count against financial aid the following year, according to Mark Kantrowitz, publisher of the college-savings website FinAid.org. Kantrowitz says loans taken out against a policy's cash value may or may not count against financial aid depending on the school.

Another savings vehicle that offers some of these same advantages is the Roth IRA. Like life insurance, money invested in a Roth IRA grows tax-free, contributions may be withdrawn tax- and penalty-free if used to cover college costs (for those age 59 1/2 or older, earnings may also be withdrawn tax- and penalty -free), and funds in the account have no effect on financial-aid calculations. However, unlike life insurance, contributions to a Roth IRA are limited to $5,500 per year ($6,500 if age 50 or older), and income limits mean that high earners may not be eligible to make direct contributions to a Roth. (Individuals of all income levels can, however, employ a maneuver called a backdoor Roth IRA, opening a traditional nondeductible IRA and then converting it to a Roth.)  

A Low-Risk Way to Save
Dwayne Burnell, a Seattle-based financial advisor and co-founder of the financial-advice website FinancialBallGame.com, is a proponent of using life insurance to save for college. He recommends only using a whole life policy for this purpose because it is safer than other types of cash-value insurance. Whole life policies typically are invested in low-risk fare such as investment-grade bonds and Treasuries, whereas variable life insurance may be invested in stocks. In fact, it is this stable, low-risk profile that makes whole life insurance a compelling option for some college savers, Burnell says.

"You don't know how much your 529 is going to be worth at any point in time, especially when you need it," Burnell says, whereas a whole life policy can provide steady, predictable growth because of its more conservative nature. "When I put the money into this policy I know that I don't have to worry about whether it will be there at [age] 18. It removes the worry factor." 

Risk-averse college savers who prefer using a 529 plan, perhaps to take advantage of their state's income tax deduction on contributions, might pursue a similar strategy by selecting the plan's fixed-income investment option. However, unlike assets invested in cash-value life insurance, 529 assets do have a small negative impact on need-based financial-aid eligibility.

Another key advantage of using life insurance to save for college, Burnell says, is a provision known as "uninterrupted compounding" that allows money in a cash-value policy to continue to grow even if the policyholder takes out a loan against it. So if you have a policy with a $70,000 cash value and take out a $40,000 loan against it, your policy will continue to earn interest based on that $70,000. "It's the only product on the planet that has that feature," Burnell says. 

Of course, you will have to pay interest on the loan, and if that interest rate is greater than the one you receive on the cash-value policy amount, the strategy probably doesn't make sense.

Also, unlike a 529, which can only be used to pay college-related costs, the cash value of life insurance may be used for any purpose. So if a child decides not to attend college or if an emergency arises, the account may be tapped without penalty. 

Returns May Not Keep Pace With Rising College Costs
If one of the primary benefits of using whole life insurance as a college-savings vehicle is its low-risk approach, the question then becomes whether it can provide returns sufficient to keep pace with the runaway tuition inflation occurring at many colleges and universities. Tuition and fees at public four-year institutions have increased by an average of 5.2% beyond inflation during the past decade, according to statistics compiled by the College Board.

Many life insurance policies in force today provide a return of around 4%, though some are higher. But Peter Katt, a fee-only life insurance advisor based in Mattawan, Mich., says that as older bonds with higher interest rates held by insurance companies reach maturity, those interest payouts almost certainly will decline. "When I work with a new client I tell them these numbers are going down. They are not sustainable," says Katt. ​

Potentially a bigger problem for college savers is that cash-value life insurance generally makes sense only for those holding it for the long term. Early premiums paid on the policy help cover commission and other expenses, meaning cash value grows slowly at first. Also, a policyholder who decides he or she no longer needs the policy once his or her children are out of school and who decides to terminate it early--typically within the first 10 years or more--may incur surrender charges that reduce the cash value. Parents whose children are within a decade from attending college and who are considering opening a new cash-value life insurance policy in part as a way to save for college should be wary of these factors, which act as a drag on the potential return of a cash-value policy. 

Katt, who doesn't sell life insurance, says he does not necessarily recommend it as a way to save for college but will provide advice for clients who wish to use it. He recommends only using a policy from a mutual insurance company (a company owned by its policyholders as opposed to one owned by stockholders) such as Northwestern Mutual, Mass Mutual, or Guardian, which usually take fewer risks than stockholder-owned companies that are under greater pressure to boost profits. It's this risky behavior that landed several stockholder-owned insurers in hot water during the financial crisis. Katt also recommends choosing a policy with a low death benefit to reduce the amount of commission paid on the policy.

Costs, Lack of Transparency Raise Red Flags
Despite the potential appeal for those looking for a conservative, tax-efficient way to save for college, there also are questions about the benefits of using life insurance for this purpose. Chief among these is the high cost of cash-value life insurance and the hefty commissions associated with such policies.

Kantrowitz, a nationally recognized expert on college savings, says he's heard people consider using life insurance to save for college more often lately, and he doesn't think that's a good thing.

"I think this is an abusive practice that should be banned," Kantrowitz says of the marketing of life insurance as a college-savings vehicle. "The pitch is it doesn't have an impact on taxes or financial aid, but it's to the benefit of the salesperson, not to the benefit of the family."

Kantrowitz says that anyone considering buying cash-value life insurance to save for college must consider all associated costs, including how much they are being charged for the death-benefit component of the policy compared with what a term life policy would cost. Also, prospective buyers should carefully review restrictions such as what happens if the policyholder dies and what happens if he or she takes out loans.

Another alarming trend Kantrowitz says he's been seeing is insurance agents encouraging clients to take out home equity loans to fund life insurance policies as a way to save for college, thereby adding borrowing costs to an already-precarious financial equation.

To make matters worse, says Kantrowitz, many of the families to whom life insurance is being marketed likely don't qualify for need-based financial aid anyway, eliminating one of the strategy's key advantages. "People who have enough assets that sheltering them makes a difference almost always have enough income that the income alone eliminates eligibility for financial aid," he says.

Do Your Homework Before Moving Forward
The high cost of college, combined with many investors' aversion to risk in the wake of the financial crisis, has surely added to the appeal for college savers to use life insurance to meet their goals. And for those seeking a relatively conservative investment vehicle--who are confident that their student or students may be eligible for need-based financial aid, who like the flexibility afforded by using the life insurance strategy, and who need long-term life insurance coverage--it may make sense. But there is a high bar to clear to arrive at that conclusion. Determining whether to use life insurance for college savings requires a rather complex cost-benefit analysis that could be cumbersome for many consumers. Before signing on to such a plan, here are some suggestions.

• Ask questions. A lot of them. Make sure you understand exactly how the policy works. What are the premiums? What are the penalties for failing to pay them? What is the rate of return, and is it guaranteed? How long must you hold the policy before that rate of return is realized? How much of your premium goes to fees for the insurance company and a commission for the salesperson, and over what time period? 
  
  
• Consider having the policy and your college-savings plan reviewed by a professional who can give you an objective opinion. Do not take at face value numbers or advice given to you by someone who stands to make a profit off your decision. You might talk to a fee-only financial advisor for this purpose, preferably one with college-planning experience.
  
  
• Consider alternatives to using life insurance that may accomplish the same goal. If you are looking for a low-risk college-savings vehicle, consider opening an account in a low-cost 529 plan that offers a fixed-income portfolio option, or think about opening a conservatively invested Roth IRA. These, coupled with term life insurance, may provide a more cost-effective way to achieve many of the same goals provided by cash-value life insurance. Also, while 529 assets do count in need-based financial-aid calculations, their maximum 5.64% reduction in aid is a relatively low price to pay for what might be a less expensive savings strategy. Plus contributions to your state's 529 plan may be deductible on your state income tax, something life insurance premiums (and Roth IRA contributions) are not.

Whether using life insurance, another approach, or a combination of approaches to save for college, the most important thing is that you understand and are comfortable with your decision. Don't let a sales pitch--whether it be from a relative, an insurance agent, or a financial company--be your sole source of information. Educate yourself on how different college-savings vehicles work, and if you do it well you should have less to worry about when it's time to pay for your child's education.