Saving for college
Why your clients should take another look at whole life insurance.
September 20, 2012
by Douglas P. Duerr, CPA/PFS
A child’s higher education is one of the largest expenses a family saves for during their lifetime. With the costs of funding education rising significantly, it is a planning need most families should address sooner rather than later. All too often families do not begin saving until the child is older. As a result, precious years of savings and possible growth of the underlying investments are lost.
Various college savings plans are available. The most popular are the qualified tuition programs (QTPs), better known as 529 plans, and Coverdell Education Savings Accounts (ESAs). These are the most commonly used plans because of their tax-free earnings growth as well as tax-free distributions as long as the funds are used for qualified education expenses.
Life insurance as an alternative savings plan
While 529 plans and ESAs are the most popular savings vehicles, there are other, nonconventional savings options that can work just as well, if not better, depending on an individual’s situation. A whole life insurance policy is an option that some very conservative individuals may like, given the guarantees available in an insurance contract. However, it needs to be structured properly.
When using an insurance product for any type of savings, clients must know all of the benefits as well as the drawbacks. First, clients need to fully understand that they are purchasing life insurance and not just an investment product. With that comes all of the expenses associated with life insurance. This type of policy needs to be funded with either a significant initial contribution or annual contributions in order to accumulate enough cash value to pay for the benefit. Clients also need to decide whether to purchase a variable product or a guaranteed investment contract (GIC). For a more conservative individual, a GIC increases based on a set guaranteed interest rate for the life of the contract. This product has limited upsides, but the guaranteed return makes it attractive to some investors.
Overfunded insurance policies
Some people use overfunded insurance contracts for college funding in several situations. Parents sometimes purchase a whole life contract used for needs such as:
There are also instances in which parents do not want to save for their child’s education in a traditional 529 account because they are not sure whether their child will attend college. The fear, justified or not, is that if they fund a 529 plan and their child decides to not attend college, the only way to get the money out of the plan would involve paying ordinary income tax and a 10% penalty on the withdrawals. By overfunding an insurance policy, they can have some additional control over the investment and its future use as well as the death benefit of the life insurance policy.
Overfunded insurance policies can also be put in place by employers for a key employee. By doing so, they can offer an additional benefit to the employee. The cash value that builds up can be used for the employee’s child’s education. The annual contributions would be income to the employee, and there should also be a vesting schedule agreed to by the employee and the employer. However, to avoid being subject to the rules under Sec. 83 for property transferred in connection with the performance of services, the arrangement should not have provisions requiring the employee to forfeit the policy or reimburse the employer for premium payments if the employee fails to meet the vesting conditions. Using this method, the employee will receive the additional funds and be able to use them for a future expense such as college. The employer also creates a more compelling reason for the employee to remain with the organization for the vesting period.
While using a whole life insurance policy is certainly an option, it is not the most likely or cost-efficient one. For this to work properly, it needs to be appropriately funded. It is also critical that all distributions be withdrawn properly to ensure the withdrawal does not invalidate the insurance contact. Handling withdrawals incorrectly can also create a taxable event.
Prior to investing in a 529 plan, clients should consider whether their state, or the designated beneficiary’s state, offers tax or other benefits that are only available for investments in that state’s qualified tuition program. Many websites help explain the various benefits of different state-sponsored plans, such as savingforcollege.com and 529solutions.com. Withdrawals used for qualified expenses are federally tax free, though tax treatment varies by state.
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Douglas P. Duerr, CPA/PFS, CFP, is a registered representative with, and securities offered through, LPL Financial. Member FINRA/SIPC. CA Insurance Lic #0H23357.
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