Yahoo Finance Compare Life Insurance, 529 Plans for College Savings
Miguel Palma, an accountant in Dublin, California, set up a cash-value life insurance policy when his daughter was young. By the time she was ready for college, he had enough saved in the policy to borrow from the accrued value to pay her tuition.
One of the reasons Palma chose life insurance as a savings vehicle is because of its flexibility. In a cash-value life insurance policy, sometimes called permanent life insurance, buyers can overfund their premiums to create a cash value that grows tax-deferred within the policy. Then, the policyholder can borrow from the cash value, tax-free as long as the policy remains in effect, for any purpose, college included.
"With life insurance, you have flexibility," he says. "If your son or daughter gets a merit scholarship, then they can go out and use that money to buy a house."
And while Palma sells insurance through his practice, Palma Financial Services Inc., he acknowledges that life insurance is just one option for funding college. "For some people, it may not work," says the CPA and personal financial specialist.
A more common strategy for college savers, 529 college savings plans, also have tax advantages, but withdrawals must be used for qualified education expenses or investors suffer penalties and tax consequences.
Parents considering both strategies need to consider the trade-offs of the two vehicles.
Know the four types of people who can [benefit from 529 plans.]
-- Fees: A cash-value insurance policyholder will have to pay a premium for the death benefit as well as a commission to the insurance agent. Because of the higher costs, it can take seven to 10 years for a policyholder to begin accumulating the cash value that warrants setting up the life insurance, Palma says.
Troy Miller, a certified financial planner in Bozeman, Montana, who specializes in college and retirement planning, says a life insurance policy intended for college needs to be "properly funded and properly designed," which means cutting insurance agents out of some commission and designing a policy with a lower death benefit, to increase the cash value.
Within permanent life insurance, there are two types: Whole life insurance has fixed costs and often a guaranteed minimum return, while universal life insurance has more variable costs and returns.
In addition, if policyholders take out a loan against the cash value, they will likely owe interest on the loan, but it may be as low as zero or 0.5 percent, because they'll also receive a credit, Miller says.
529 plans also carry fees that vary by portfolio, and if it's an advisor-sold plan, an investor may have to pay a fee to a broker.
Explore ways to [vary college savings strategies.]
-- Investment returns: Returns on life insurance depend on the type of policy. Miller says dividends on a whole life insurance policy, which he prefers because of the fixed costs, could pay between 3 and 6 percent over a period of seven to 10 years.
A universal life insurance policy may be tied to a market index, such as the Standard & Poor's 500 index, and often has a cap on earnings: If the market goes up 15 percent, the client may only gain 12 percent. On the other hand, if the market has a downturn, the client does not lose gains or principal because of protective clauses, Palma says.
In a 529 plan, investors choose from a portfolio that could include stock mutual funds, bond mutual funds, money market accounts or age-based funds. There are no guarantees on returns within a 529 plan, but also no caps on returns.
-- Financial aid: For parents who borrow against a cash-value life insurance policy for college, the money is not included as an asset or income on the Free Application for Federal Student Aid or the CSS Profile, which is used by some schools to determine financial aid, and thus will not affect the amount of need-based financial aid for which a student is eligible.
Distributions, on the other hand, are considered untaxed income on the FAFSA, and will affect aid eligibility at a rate of 47 percent for parents and 50 percent for students on the amount of the withdrawal.
Find out more about [how colleges consider 529 plans in need-based financial aid.]
A 529 plan could reduce aid eligibility by as much as 5.64 percent of the asset value, says Troy Onink, CEO of Stratagee.com, a college planning service. This is only a factor for students who think they will be eligible for need-based aid.
Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.
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