Using Life Insurance instead of an Internal Revenue Code Section 529 Qualified Tuition Program

Grandparents are often very fond of establishing savings accounts intended for grandchildren’s education. If they can do so with tax advantages, it is even better! Frequently a grandparent will consider starting a Section 529 Savings Plan for the grandchild because financial advisors often point out the tax-advantaged growth of those plans. These accounts are known as 529 plans because of Section 529 of the Internal Revenue Code that provides for tax-deferred growth on the earnings and tax-free use of the funds when they are used for qualifying education expenses. They are plans operated by a state or an educational institution, with tax advantages for a designated beneficiary, such as a child or grandchild. They are actually called a “qualified tuition program.” The new tax law expands the use of 529 savings accounts to include K-12 private school tuition, but there are still limitations on other uses of 529 plans.

529 funds must be used for qualified education expenses. Take money out for other purposes, and you could incur a 10 percent penalty as well as an income tax bill. If the rent paid to a landlord, for example, is higher than the school’s room and board estimate, then the excess is not considered a qualified expense. There are limitations on what a qualified expense is, but it generally includes tuition, required books and equipment and some room and board expenses.

As a result of these and other drawbacks, many families also use cash value producing life insurance as a potentially superior way to accumulate funds for education expenses and also for other purposes that 529 plans are not designed to address. Strauss Attorneys, PLLC are not insurance agents or financial advisors, but we are more than happy to work with advisors as a team on client issues.

For educational purpose, the type of life insurance policies that may be used includes certain varieties of traditional Whole Life, or Universal Life policies, or Variable Universal Life policies. There really are many choices and possible configurations depending on goals and amount of financial resources that a grandparent (or for that matter, a parent) is willing to commit.

When the donor desires more guarantees, they generally use Whole Life policies designed with higher cash value accumulation in mind and less focused on increasing death benefits. One of our friends who is a licensed insurance agent provided us with the following example of how a whole life contract can grow over time to provide funds for a college education or for other purposes. It is important, however, to get your own illustration for your specific situation.

Example: Let’s say Grandma gets permission to purchase a whole life policy on the life of her two year- old grandson. She anticipates that he will start college in 16 years at the age of 18. She is willing to put in $5,000 per year into the policy. In order to prevent the policy from being treated as a Modified Endowment Contract for tax purposes, the initial death benefit in the event the child dies, will be $655,084, made up of a base policy with a premium of $2,500 per year, plus a Paid Up Additions Rider premium of another $2,500 per year. The projected cash value in the policy 16 years after the purchase is estimated to become $101,807; there has been $90,000 contributed. A portion of these values is guaranteed by the traditional life Insurance contract. The rest is based on a projection of the policy dividend rates which are not guaranteed.

When grandson starts college at age 18, Grandma can either borrow against the cash value on an income tax-free basis as long as the policy stays in force or could withdraw dividends that were providing paid-up additional life insurance coverage and borrow from the guaranteed cash values. If premiums of $5,000 continue to be deposited into the policy for 7 more years until grandson is 25, and then stops, the annual policy dividends will then be projected to be $3,887(and growing in the future), which is more than enough to pay the base $2,500 annual policy premium if necessary. (No more out of pocket premium payments are anticipated on the Paid Up Additions rider after age 25.) If instead policy premiums of $2,500 per year are paid into the policy from out of pocket and if the policy is kept in force beyond college and graduate school, at grandson’s age 65, the policy could have over $1.7 million dollars in cash value and a death benefit of over 3.2 million dollars. (Premiums paid for over 63 years would have been $220,000). It is important to get an illustration to see the assumptions and how powerful a vehicle this can be with continued funding.

These dollars in the life insurance policy could be used for many purposes even if grandson does not go to college or if he receives a full scholarship; think first home, or wedding expenses/honeymoon, or starting a business, among others. If the policy stays in effect, then grandson can have used a good amount for college and still have an insurance policy for use as death benefit or retirement vehicle. The policy has more flexibility in this regard than the alternative 529 account which has no death benefit and really limited use for retirement (because of the penalty).

Since it is a whole life policy, the cash value accumulations are more predictable. Further, if the grandchild becomes uninsurable or needs death benefit for his family, the insurance policy is there to serve that purpose whereas the 529 plan is strictly available (without penalty) for qualified education expenses.

Many grandparents and parents worry that having a chunk of money set aside for college could impact their grandchild’s/child’s eligibility for scholarships or other financial aid. They are right to be concerned because while merit-based scholarships are unlikely to be affected, financial need programs or need-based grants can be affected by the 529 plan since it is considered an asset of the student. The amount of the affect on financial aid depends, in part, on who owns the 529 plan and what financial aid application the institution uses. It is usually better for the grandparent and not the parent to own the plan, especially for the more commonly used FAFSA (the Application for Federal Student Aid), but it does count against the student when withdrawals are made.

On the other hand, insurance that is not owned by the student (but rather by the grandparent) should protect the funds in the policy against counting for financial aid or need-based purposes even on the less commonly used CSS form that requires listing of 529 plans. But, even with the 529 plan, all is not lost if the grandchild gets a scholarship based on merit. You can always take a non-qualified withdrawal from the 529 plan and pay the 10% penalty (or if there is a scholarship you can pay tax on the earnings) or change the beneficiary to another family member.

Because the grandchild does not own the insurance policy, the grandparent can continue to control the funds even after the grandchild turns 25. The remaining assets in a 529 plan can continue to be owned by the designated owner, but there may not be much left after paying for the education.

Having the policy in force beginning at a young age accomplishes lifelong insurance coverage on the grandchild regardless of future changes in the grandchild’s insurability due to health or dangerous hobbies.

What started as an education policy could end up as a valuable retirement plan in an age where many corporations no longer provide pension plans.

In short, there is no one size fits all. Both the 529 plan and the life insurance solution offers tax and non-tax benefits, but they offer different levels of flexibility, impact on scholarships and long-term advantages (e.g., the insurance can be used for retirement or pledged as collateral for loans). This discussion is meant to be a high-level overview; we encourage you to get an illustration based on your particular situation.