Saving for College: Life Insurance or 529?

A college education may be the key to a better job for most Americans, but it comes at an alarmingly high cost these days. The average bill for tuition and fees was $34,740 at private colleges in the 2017–2018 school year, according to the College Board. The average was $9,970 for state residents at public colleges and $25,620 for out-of-state students at public universities.

Clearly, most families need a long-term savings plan if they hope to help their children avoid a mountain of student loan debt. For nearly three in 10 households, the method of choice is the tax-advantaged 529 plan.

These state-run accounts are similar to a Roth 401(k) or IRA, but they're aimed at college rather than retirement savings. You can invest in a basket of mutual funds and the earnings grow tax-free until you make a withdrawal. As long as you use the money for certain education-related expenses, you will not be charged capital gains tax on the funds you remove.

Most states also offer a tax deduction or credit for contributions to their plan, which only adds to their appeal.

While the 529 is in some ways the gold standard when it comes to putting away money for college, it’s not the only path that offers tax benefits. Another option is to take out permanent life insurance, which, unlike term coverage, has a tax-deferred savings component. If given time for the plan’s cash-value segment to grow, parents can draw on these funds tax-free to pay tuition and related expenses. (For more, see Are 529 College Savings Plans Right For You?)

Here’s how permanent life insurance works as a college savings tactic: For every dollar you pay in premiums, a portion goes towards the death benefit and another portion is diverted to a separate cash-value account. (For more, see 5 Things You Didn't Know About Life Insurance.) 

From an investment perspective, whole life insurance is generally the safest version. The issuer credits your account by a guaranteed amount, although it may pay more if the investments perform well. Most policyholders can expect anywhere from a 3% to a 6% return after the first several years.

Other types of coverage, such as variable life insurance, give policyholders a degree of control over their investment. In this case, you select the sub-accounts – essentially mutual funds – that you want to be attached to your policy, and your account’s annual return is pegged to the performance of these underlying investments. The potential reward is greater, but there’s a risk that your balance could fall in a given year if the market takes a plunge.

When it’s time for your son or daughter to start college, you can take out a loan against your cash balance. The insurer will reduce your death benefit if you don’t pay back the loan, but that’s not necessarily a drawback for those who intended the policy primarily as a college savings plan.

In most cases, the principal portions of these loans are tax-free. (For more, see Cut Your Tax Bill With Permanent Life Insurance.)

When contrasted with a 529 plan, life insurance has a couple of benefits. One is flexibility. Suppose your child decides against going to college. Any earnings in your 529 account, but not your contributions, will be subject to ordinary income tax rates. There are some plans that allow the beneficiary, who is usually in a lower tax bracket, to withdraw the funds. But it’s still a significant tax hit that life insurance owners don’t have to face. 

The other big advantage of insurance is that it’s not included in financial aid calculations. Conversely, money in a 529 account counts as a parental asset, whether the parent or child is the owner. And up to 5.64% of these assets are included in the applicant’s Expected Family Contribution. (For more, see 5 Ways To Get Maximum Student Financial Aid.)

But there are less attractive features of permanent life insurance. There are upfront and recurring fees that can make stock and bond fund fees look like a steal. For example, 50% or more of your first-year premiums will typically pay the insurance representative’s commission. As a result, you’re starting in a pretty big hole. 

It can take 10 years or more for your cash value to surpass what you paid in premiums. So unless you buy a policy before your kids are in kindergarten, it’s hard to make a case for life insurance as a way to build up your assets.

On top of that, heavy annual expenses continue to weigh down your earnings. Most permanent life policies charge upwards of 2% per year in administrative and investment costs.

The average fund in a 529 account that is sold directly rather than through a financial advisor has an expense ratio of around 0.5%, according to research firm Morningstar.

Keep in mind that you can shop around for other states’ 529 plans in order to find one with good investment options and low fees. In most cases, you can use the funds to pay for college somewhere else (see Top Seven 529 Plans for 2015).

Even though you may in effect have to forfeit a small chunk of your account because of financial aid rules, you’re likely to come out ahead by using the 529 because of the lower expenses.

Whole life insurance policies might be something to consider if you start saving early and are particularly risk-averse. But the simplicity and much lower fees associated with a 529 arguably make these plans a better option for most families.