Are your children planning to go to college? That’s great news, but it’s also a huge financial obligation. It’s smart to have a savings strategy in place long before your kids step foot on campus to ensure you have the funds they’ll need.
While 529 plans were designed to encourage saving for college, they’re not the only option out there. Life insurance policies that build cash value are a viable alternative. Plus, they can offer more flexibility if you have other financial goals and obligations and if you have any doubt that your kids will go down the college path.
Need a crash course on life insurance? Before deciding between term life insurance or a 529 college saving plan, familiarize yourself with the basics of life insurance. Learn everything you need to know in our handy guide to life insurance.
Should I buy or invest in life insurance or a 529 plan?
It depends on your financial goals and obligations, as well as the degree of flexibility you’re after. A 529 plan is clear cut: It helps you save for future college costs, which climb every year. Life insurance is exactly that: Insurance. It protects your family in the long run, but some policies offer the flexibility to withdraw funds during your lifetime to pay for things like loans and college costs.
To make an informed decision, think about these factors:
Income limits. There are no income limits for a 529 plan. For life insurance, you have to qualify for coverage, and part of that is providing proof of income and other earnings to the provider. This determines the amount of coverage you’re offered.
Contributions. With life insurance, you’ll pay a monthly premium that’s determined by your insurance company. The rate reflects your age, gender, health, family medical history, occupation and lifestyle. Permanent policies — the kind that build cash value — aren’t cheap. As for 529 plans, the amount you contribute is up to you — it just shouldn’t exceed the cost of education or the limit set by the state. As of 2018, you can make contributions of up to $15,000 per individual without being subject to the gift tax. This amount doubles to $30,000 if you’re married and choose to split the contributions.
Tax breaks. Although your premiums and contributions aren’t tax-deductible, both 529 plans and permanent life insurance policies grow tax-free. A 529 plan has one advantage: In addition to federal tax savings, over 30 states offer a full or partial tax credit on contributions. For instance, in New York, families get a state tax deduction up to $5,000 per parent.
Interest. Both 529 plans and permanent life insurance policies earn interest over time. Before signing the dotted line, read up on the company’s investment strategy and approach to risk, like whether they’re conservative or aggressive, along with their recent performance.
Investment returns. There are no guaranteed returns on 529 plans, but there are also no caps on returns. The returns on life insurance depend on the type of policy. For example, universal life policies are usually tied to a market index, like Standard & Poor 500, and often have a cap on earnings.
Flexibility with funds. A 529 plan offers tax-free withdrawals only when the funds are used to pay for qualified education expenses. For colleges, universities and trade and vocational schools, this includes tuition, fees, books, supplies, computers, and in some cases, room and board. It’s an investment account with a specific goal. The money is portable, though: You can transfer it from state-to-state once a year and change your beneficiary to another qualifying family member twice a year. Meanwhile, your life insurance policy can be used to pay for living expenses around campus, as well as things that have nothing to do with college, like putting a down payment on a house.
Withdrawing cash. As the account owner or policyholder, you can withdraw cash from your 529 plan and permanent life insurance policy, such as whole life. However, these withdrawals are subject to terms. If you use money from your 529 plan to pay for things that are unrelated to education, you’ll be subject to federal income taxes plus a 10% penalty on earnings. If you take out a loan on your life insurance policy, you won’t face the same kind of tax hit. But it may lower the death benefit your beneficiaries receive, and you’ll most likely be charged interest.
Maintenance. Both plans are pretty low maintenance. In most cases, you can “set it and forget it” with the help of automatic payments. Universal life policies also allow you to adjust your premium payments to suit your situation.
Fees. Both investment options are subject to fees, but generally, 529 plans come out on top. For 529 plans, administrative and advisory costs can range from 0.25% to 1.85%, plus any broker fees. The charges on cash value insurance policies tend to hover around 2%, thanks to commissions.
Financial aid. A 529 plan is a financial asset, and it can impact a student’s financial aid eligibility by up to 5.64%. If the student owns the plan, that rate jumps to 20%. If your college savings plan is hinged on financial aid, tread carefully. Meanwhile, life insurance policies aren’t seen as parental assets, so they aren’t included in financial aid calculations.
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Can I buy or invest in both life insurance and a 529 plan?
Yes. The savings in a 529 plan can only be used for education, while life insurance policies are usually more flexible. Permanent policies allow you to use your cash value for whatever you want, so if you have financial obligations outside of college costs, you may want to look into buying both.
A life insurance policy offers your family a sense of financial security for the future. If you die prematurely, your beneficiary can use the death benefit to pay for college. A 529 plan is a common college savings strategy — and for good reason. But like all investment products, it has its limits, so research, compare and look at the big financial picture before buying anything.
Other things to consider
Here are some other things to think about when deciding whether you should buy life insurance, invest in a 529 plan or do both:
Do you need strong, fast returns to fund the cost of tuition? If so, a 529 plan might make more sense. Much like 401(k)s, you can choose from a variety of investment vehicles, like stocks and mutual bonds, as well as the level of risk you’re comfortable with. Whole life policies provide guaranteed returns, which are great over the course of a lifetime but may not be suitable for short-term financial goals.
Do you need to be able to withdraw cash whenever you need to? With 529 plans, you can withdraw as much as you need to pay for qualified college expenses. On the other hand, your cash-value life insurance policy has to reach a certain amount before you can start withdrawing. This is set by the individual insurance company and can take years.
What if your child doesn’t go to college? If you have any doubt that your child will go to college, it’s worth looking into life insurance. You can easily pivot and use your life insurance policy’s cash value to pay for something other than school. While you can cash out your 529 plan in the case that your kid doesn’t go to college, you’ll face federal income taxes and a 10% penalty on earnings.
What if the prospective student wants to study abroad? The funds in 529 plans can only be withdrawn without penalty for colleges that have been accredited by the U.S. Department of Education. However, there are a bunch of overseas schools on that list.
What if your child gets a scholarship? With a 529 plan, the 10% penalty is waived, but you’ll still have to pay federal income taxes on the money you saved since it’s not being used for education expenses. Again, with life insurance, you can reroute that money to pay for things other than your child’s education, like to put a down payment on a house.
Do you need to save money for other schooling? Maybe you want to pay for private elementary or secondary school. A 529 plan only allows you to withdraw up to $10,000 a year for K–12 tuition, so a life insurance policy may be a better fit.
As investment products, 529 plans and life insurance policies have a long list of benefits. The best savings strategy for you is the one that suits your financial situation and goals. If you’re interested in purely paying for college costs, a simple 529 plan might make more sense for your family. But if you’re looking for flexibility with your funds, consider taking out a permanent life insurance policy — either on its own or along with a 529 plan.
Frequently asked questions
If you use your 529 plan for something other than qualified education expenses, you’ll have to pay both federal income taxes and a 10% penalty on the earnings. However, if the beneficiary gets a full scholarship to college, that penalty is waived.
Before cashing out, consider that a 529 plan can be used to pay for four-year colleges, as well as two-year associate degree programs, trade schools and vocational schools in the US and abroad as long as they’ve been accredited by the US Department of Education.
As the account owner, you can change the beneficiary to another family member, such as a sibling, first cousin, aunt, grandparent or even yourself. Most 529 plans allow you to change your beneficiary twice a year. If your beneficiary doesn’t use up all the funds, you can also transfer the balance to a different family member.
Some examples of qualified expenses include tuition and fees, books, supplies, and computers or laptops. You may even be able to claim room and board if the beneficiary is at least a half-time student.
In 2018, you can make contributions of up to $15,000 per individual without triggering the gift tax. If you contribute more than $15,000, you’ll have to report the excess on Form 709 when you file your taxes.
Maybe. A term life policy doesn’t build cash value, but permanent policies like whole life and universal policies do. They offer a death benefit plus a cash accumulation account, which you can tap into during your lifetime.
Depending on the insurance company and how long you’ve held the policy, you might be able to borrow against it, withdraw cash permanently or use the cash value to pay premiums. If you choose to take out a loan on your policy, it may lower the death benefit your beneficiaries receive, and your insurer may charge you interest.
Katia Iervasi is a staff writer who hails from Australia and now calls New York home. Her writing and analysis has been featured on sites like Forbes, Best Company and Financial Advisor around the world. Armed with a BA in Communication and a journalistic eye for detail, she navigates insurance and finance topics for Finder, so you can splash your cash smartly (and be a pro when the subject pops up at dinner parties).
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