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Usually, the first thought parents have when saving for college is to use a 529 College Savings Plan for their children. But since their creation back in 2001, 529 plans have undergone a litany of rule changes, many of which actually make 529 plans less attractive for college savings.
Today, I’ll run down the pros and cons of these plans and offer a potentially more attractive alternative.
The major benefits offered in 529 plans are:
- State income tax deductions or credits (varies from state to state; doesn’t apply to Texans, since we don’t have a state income tax)
- Federal tax deferral on the growth in a 529 plan, which becomes tax-free if withdrawals are made within the rules
- Transfers assets outside of the taxable estate as it concerns federal estate taxes (only individuals with estates more than $12.9 million benefit from this)
Those benefits, though, come with rules limiting you to:
- How much you can contribute
- For whose benefit it can be
- What it can be used for
- And how it can be withdrawn
Failure to comply with the rules makes the donor/owner (and sometimes the beneficiary) subject to penalties and taxes.
There’s an alternative option that offers many of the same benefits with potentially fewer limiting rules: cash-value life insurance via a whole life or universal life policy.
When a child is born, parents usually feel the need to buy additional life insurance to provide for the child and surviving spouse in the event of an untimely death. Most of the time, they purchase a term policy to fill this need.
There’s a good reason for that: According to an article in Forbes, the average cost of a $1 million term policy for a 30-year-old is just $25 to $35 per month!
Now if that same parent wanted to start setting aside $500 a month for a college savings plan, they could combine the two and pay $530 a month into a cash-value (that is, non-term) life insurance policy. The growth rate on such policies would likely be better than that of a bond ETF or bond mutual fund, plus they offer a guaranteed minimum interest rate that a bond fund cannot provide.
If there is a desire for a more aggressive investment, a variable universal life insurance policy can have the cash value invested in equity-based, mutual fund-type accounts that could provide more growth.
Unlike a 529 plan, life insurance has virtually no limit on how much you can invest. (There are some IRS guideline limits, but they are very high and can be increased with a larger amount of coverage).
An additional benefit is that the growth of the cash value in a life insurance policy is taxed deferred like a 529 plan. 529 plans allow for tax-free withdrawals for approved higher education. Life insurance allows the principal (total amount paid into the policy) to be withdrawn first without any taxation. Also, modern policies allow for 0% (or near 0%) interest loans to be made, thus allowing use of the funds tax-free.
A key difference here is that life insurance allows you to withdraw or borrow for anything you wish; there are no rules that funds must be used for qualified higher education expenses. This gives parents (and their children) the flexibility to look for opportunities beyond traditional college (that is, apprenticeships, starting a business, etc.).
Of course, parents could also use that money for their own purposes.
Another drawback to 529 plans is that they must be reported on the FAFSA (Free Application for Federal Student Assistance), and its value is counted as a family asset (unless owned by a grandparent). This reduces the amount of financial aid for which the student is eligible. Life insurance cash values, on the other hand, are not reported as part of FAFSA. Thus, for example, a family could have $500,000 in life insurance cash value and possibly still qualify for financial aid.
The downside is that life insurance is still considered a part of a parent’s estate. There are no state income tax benefits to paying for life insurance, but, as I mentioned, these are benefits that only apply to very wealthy families and people living in states with a state income tax. In Texas, life insurance cash values are protected from the claims of creditors and bankruptcy just as 529 plan assets are protected.
For those reasons, many practitioners prefer grandparents utilize 529 plans for college planning, while parents can utilize cash-value life insurance for their kids’ college.
It’s best to consult with a Certified Financial Planner™ who is “fee only” and does not get paid commissions from life insurance policies before starting any college savings plan.
Wes Shannon CFP® is a Certified Financial Planning Professional for Brazos Wealth Advisors.