Getty Images (1). Art: Jillian Sellers.
Let's take a moment to talk about something that parents squirreling away money for their child's college education may not fully realize: When you use a 529 plan to save money for higher education costs, colleges and universities will count that accumulated cash among your family's assets when calculating how much financial aid your child may or may not qualify to receive. However, the money amassed in a whole or universal life insurance policy is not counted as an asset for financial aid qualification purposes.
Why does this matter? Because with the steep (okay, downright debilitating) cost of college tuition these days, families need a well-thought-out strategy for minimizing out-of-pocket costs and a whole or universal life insurance policy may be one approach to doing that.
"Most people are sold on the idea of 529 plans, but 529 assets can reduce the amount of financial aid a student receives. Having whole life insurance won't, everything else being equal," May Jiang, tax and financial advisor with OffitAdvisors, tells Parents. "Switching your savings strategy from a 529 plan to a whole life insurance plan can effectively improve your child's chances of earning more financial aid."
Before getting too deep into this discussion, let's be clear. None of this is to say 529 plans aren't a good choice or a valuable savings tool when it comes to setting aside money for college. They are. But every family has different circumstances and needs and it's important to be aware of all the tools available when it comes to tackling the ever-increasing cost of college.
Here's a closer look at how to use life insurance to help fund higher education.
Which policies can be used to fund college?
If you're contemplating using life insurance to help pay for your child's college education, the first thing to understand is that not all policies are up to the task. You'll want to look for a cash value policy, such as a universal and whole life insurance policy, as opposed to term life insurance, which has no cash savings component.
You can use the cash inside universal or whole policies to pay for anything, including tuition. Whole life policies are a particularly popular option for doing this.
"Whole life insurance policies have a cash value that increases over time, and the cash value you accumulate is yours to spend if the need arises," Kevin Draeger, CFP and internal wholesaler for COUNTRY Financial, tells Parents. "So, whether you need it for education expenses, an emergency fund, or a substantial payment, your whole life policy can work for you while you're still living."
Universal life insurance is also a worthwhile choice, says Clifford Caplan, a wealth manager who during the financial crisis of 2008 tapped into his own life insurance policy to cover college tuition costs for his children when his stock market assets tanked.
"The cash value from life insurance can be used almost like it is a bank account. The difference is that withdrawing funds will likely be treated as a loan, but you are really borrowing from yourself. And you can take your time to repay," says Caplan.
Ways to access the cash value
There are three primary ways to draw on the money in a cash value policy. One of the most popular options is taking a loan against the value of your life insurance policy, which you later pay back in full in order to restore the value of your policy, Amy Danise, chief insurance analyst for Forbes Advisor tells Parents.
"The insurer will charge loan interest, which you'll also pay back," says Danise.
Keep in mind, however, that the policy's death benefit will be reduced when you have an outstanding loan—and if you pass away before it's paid back, beneficiaries receive a reduced death benefit.
Another option is to take a withdrawal of cash value, says Danise. "This means you don't intend to pay the money back and you know your death benefit will be reduced," she explains.
A third and final option (and really the least ideal), is to surrender the policy entirely for the available cash value. In this scenario, you would receive the policy's cash value minus any surrender charge the insurer charges.
"Consider this only if you no longer need life insurance, because surrendering the policy terminates it. And if you have a child in college you likely still want life insurance," advises Danise.
If you're considering any of these options, contact your insurance company first and find out how much cash is actually available for withdrawal. It's also a good idea to speak with a financial advisor to weigh the pros and cons of all your options.
Expenses and fees to be aware of
Yet another factor to keep in mind when considering life insurance as a vehicle to help pay for college: fees. There's a variety of them, Shervin Eftekhari, president of Zander Insurance, tells Parents.
"Whole and universal life insurance policies may offer a savings component, but they also include significant upfront and recurring fees," Zander says. "At least half of your first-year premiums will typically go to pay the agent's commission, and it can take 10 years or more for your cash value to grow into an amount substantial enough to use for post-secondary education."
In addition, many permanent life policies charge 2 percent or more per year in administrative fees and investing costs, which will eat into the money being saved. A 529 plan, on the other hand, will cost you a fraction of the costs associated with a life insurance policy, says Zander.
A life insurance policy is essentially a tax-free savings account, says Jiang. But if you're going to use this approach to saving for college, it's important to get started early, when your child is first born, so that you have ample time to accumulate a substantial amount of money. It's also less expensive to obtain insurance when you're younger.
However, before you take any cash withdrawal from your policy, ask a professional to run a policy illustration showing you the future effect of taking the money out. This is important because when you withdraw money, you run the risk of depleting a policy's overall value so much that the policy lapses.
"What you're looking for in the policy illustration is a future problem where your cash value will drop below the minimum balance required by the insurer, which will cause the policy to lapse," says Danise.
In such a scenario, you could be on the hook for paying extra premiums unexpectedly in order to keep the life insurance in place.
"I don't think people realize this can happen. While you have that loan, you're still being charged regular fees and expenses, such as a mortality fee, which is the cost of insuring you," continues Danise. "Your premiums might keep up with these charges coming out, but they may not."
Still, says Danise, a thoughtful approach to using life insurance to cover college costs is certainly worth the discussion.
"One of the reasons to have a cash value policy is to access the cash value," says Danise. "With most policies, beneficiaries receive the face amount and not the face amount plus cash value. Someone who has a cash value policy might as well use it for their needs while they're alive."