College Funding and Life Insurance
The average annual gross undergraduate cost for attending a University of California school is about $35,000. This includes tuition, books, room & board and other fees. That is a total cost of over $140,000 over 4 years. As a result of the steep cost of a higher education, finding a way to finance this cost is an increasing challenge for families today.
One of the most common ways to save is through a 529 savings plan. The major benefit of a 529 Plan is that the investment growth is tax-free if it is used for college costs. In some states your contribution is also tax-deductible. There are other ways to fund college costs including tapping into your 401K plan, Individual Retirement Accounts, or home equity. Insurance sales people offer another option: using permanent life insurance to fund college costs. I wanted to provide a summary of how permanent life insurance works as well as the advantages and disadvantages of this option to pay for college costs.
How Does Permanent Life Insurance Work?
A permanent life insurance policy provides the insured a death benefit that lasts until the insured reaches 100 years old. In addition, a permanent life policy acts as a savings account that generates a cash value.
With each premium payment that you make, a portion goes to the death benefit and another is placed into a cash value account. The longer you own a whole life policy, the larger the cash value portion will be and the smaller the amount of your death benefit.
For example, suppose you purchase a permanent life insurance policy with a $1,000,000 death benefit. In the first year, you might have zero cash value. In year 10, your Cash Value could be $100,000 and your death benefit would be $900,000. In year 30 your cash value could be $400,000 and your death benefit would be $600,000.
In this example, if you were to pass away at year 30, your beneficiaries would receive a death benefit of $600,000 but the insurance company would keep the cash value.
What are the Advantages?
The largest benefit of a permanent life insurance policy is flexibility. You have the ability to access the cash value for any reason by surrendering the policy, taking a cash withdrawal, or taking out a policy loan (up to the total amount of the cash value). This money can be used for any purpose including paying for the cost of college. With a 529 Plan, you will be taxed an additional 10% penalty on any non-college related withdrawals. The second attractive feature of using permanent life insurance to pay for college is the accumulated cash value is guaranteed by the insurance company. Third, a permanent life insurance policy has a number of tax advantages: interest earned on the cash value grows tax deferred, withdrawals made up to the total amount paid in policy premiums are tax-free, and any amount taken as a loan from your cash value, is made tax free. The fourth advantage is that the cash value is excluded from financial aid calculations as they are not seen as parental assets.
What are the Disadvantages?
The biggest disadvantage is the cost of premiums. A 30-year-old who purchases a whole life policy with a $500,000 death benefit can expect to pay an average of $4,500 per year. The second disadvantage are the annual costs. Most permanent life insurance charge an average of 2% per year in fees. The third disadvantage is the amount of time it takes to build up a sizable cash value. It can take at least 10 years for the cash value to grow just beyond the amount paid in premiums. Fourth, any cash value withdrawals made in excess of the total premiums made will be taxed as ordinary income. Fifth, cash withdrawals and unpaid loans reduce the value of your death benefit. This could be significant if you are counting on the death benefit to support your family if you were to pass unexpectedly.
What’s the Bottom Line?
The estimated 4-year cost of a University of California education is estimated to be as high as $140,000 for a California resident student who lives on campus. Because of the amount of time it would take to build the cash value in a permanent life insurance policy to cover this 4-year cost, this option would make the most sense for families who are very risk averse, are high income earners, and are able to start saving very early in their child’s life.
However, it is when your children are very young that your budget is the tightest and you need the most life insurance coverage. But because the cost of a permanent life insurance policy is very expensive, the amount of coverage that you could afford would be much less than a term life insurance policy. For example, a whole life policy with a $250,000 death benefit can potentially cost $4,500 per year. You could purchase a 20 year term life insurance with $1,000,000 death benefit for $400 per year.
Unless you are a high-income household who can afford the premiums and need additional tax deferred investment vehicles, you are better off utilizing life insurance for what it is intended for: providing your loved ones with the financial protection they need in the event of your untimely death. The best way to do that is with term life insurance. The money that would otherwise go to a whole life policy can be invested in a 529 college savings plan which is much less expensive, offers tax-free growth (for college related expenses), and can provide a better rate of return.