A 529 plan vs. life insurance: which should you choose to save for college?

Do you have children who will be going off to college? That’s wonderful! However, college is expensive, with tuition and other related expenses steadily rising with each passing year. Therefore, you need to prepare for the future with a solid strategy to save money to cover all of those costs. There are many ways to save for college. But in this article, we are going to focus on the pros and cons of a 529 plan vs. life insurance. Keep reading to learn more about these two college savings options!

What is a 529 Plan?

A 529 plan (or a qualified tuition program or a Section 529 plan) is a tax-advantaged savings plan that helps you save for future college expenses. Initially, it was limited to post-secondary education costs. But in 2017, it was expanded to also cover K-12 education, and in 2019, it was further expanded to cover apprenticeship programs.

There are two main types of 529 plans: savings plans and prepaid tuition plans. The money in these savings plans grow tax-deferred and withdrawals are tax-free if they are used for qualified education expenses. Prepaid tuition plans allow the account owner to pay in advance for tuition at designated colleges and universities. This lets you lock in today’s rates. 

What is Life Insurance?

Life insurance is a contract between an insurer and you, the policyholder. A life insurance policy ensures that the insurer pays a sum of money to named beneficiaries after the policyholder passes on. You would pay regular premiums to fund your life insurance through your lifetime. 

Types of Life Insurance

Different types of life insurance are available for all needs and preferences:

Term Life: Term life insurance lasts for a set number of years, and then it ends. You choose the length of the term when you take out a policy. The common terms are 10, 20, and 30 years. The best term life insurance policies balance affordability with long-term financial strength. 

Level Term: This is a type of term life insurance that has fixed premiums every year. 

Increasing Term: Another type of term life insurance where the premiums are lower when you’re younger and increase as you get older. It is also called a “yearly renewable term.” 

Permanent: This life insurance policy remains in place for the entire life of the insured. It only ends if the policyholder stops paying the premiums or surrenders the policy. It’s also more expensive than term life insurance.

Single-Premium: The policyholder pays the entire premium upfront. This eliminates making monthly, quarterly, or annual payments. 

Whole Life: Whole life insurance is a type of permanent life insurance that accumulates cash value. 

Universal Life: This is a type of permanent life insurance with a cash value component that earns interest. Universal life insurance also has similar premiums to term life insurance. Unlike term and whole life insurance policies, there are adjustable premiums and death benefits.

Guaranteed Universal: This type of universal life insurance policy does not accumulate cash value and usually has lower premiums than whole life. 

Variable Universal: A variable life insurance policy allows the policyholder to invest its cash value. 

Indexed Universal: An indexed universal life insurance policy allows you to earn a fixed or equity-indexed return on the cash value portion. 

Burial or Final Expenses: This policy is a type of permanent life insurance with a small death benefit. Despite the name, beneficiaries can use the death benefit as they choose. 

Guaranteed Issue: This is a type of permanent life insurance policy that’s available to people with medical issues that would otherwise make them uninsurable. However, the guaranteed issue policy will not pay a death benefit during the first two years that a policy is in force (unless the death is accidental). This is a result of the high risk of insuring the person. But the insurer will return the policy premiums plus interest to the beneficiaries if the insured dies during that period. 

Pros and Cons of a 529 Plan to Save for College

Let’s explore the pros and cons of a 529 plan

The 529 plan is a good way to save for a college education. A 529 plan is an investment which means that there is some risk. However, the 529 plans are still a popular choice to save for college and the funds tend to grow with each passing year. 

You can also open as many accounts as you need. If you have more than one child, then you need to open a 529 plan for each child. 

Advantages of a 529 Plan

Now let’s consider a few of the advantages and disadvantages of a 529 plan:

Tax Benefits

Contributing to a 529 plan has some tax advantages. The earnings on funds in 529 plans are not counted as a part of your income and so they do not attract federal taxes. Your money grows tax-free as long as you contribute and withdraw within the stated requirements. 

In some states, there are also additional state tax benefits. You may also get benefits on your earnings or actual contributions. Furthermore, state-based 529 plans can also have variations.  

Low Fees

Opening a 529 account should have little or no fees attached. If you choose to open an account yourself, then you shouldn’t be charged anything. But you will have to pay fees if you use a financial advisor to open the account. There are also fees associated with withdrawing funds from your 529 plan for non-educational purposes. 

Furthermore, you will not be subject to large annual fees on your 529 plan. This is in comparison to whole life insurance plans that charge approximately 2% in annual fees. 

However, most state-based 529 plans are free of any annual charges. A few plans charge nominal fees of $10 to $25 per year for maintaining the 529 accounts. 

You Can Search for the Best Plan

Each state has its unique set of 529 plans and advantages for contributing to such accounts. Also, you don’t have to live in a state to open a 529 plan in that state. So it is worth your time to research which states may have the best 529 programs for your needs. 

While there are no restrictions on where you can open a 529 plan in the USA, some states have incentives. Currently, 7 states offer a double incentive if you live in those states and also open a 529 plan there. These states are Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania. 

When you’re shopping around for a 529 plan, you need to assess which state’s plan has the greatest potential for future earnings. But you will also need to consider the tax incentives even in the face of higher earning potential. It’s easy to figure out which state produces the highest earnings with their 529 plans as the data is available online

Also, you can choose a different state’s plan for each account you choose to have. For example, if you have an older child, you can choose a different account that is more aggressive and earn more in a short time. If you have a younger child, then you can choose another account that is conservative and earns steadily over time. 

But you don’t need to spend hours researching all the available plans. You can choose to get help from a financial advisor (preferably, a fee-only advisor). They will help you to pick the best plan based on your preferences. However, before you settle on a plan, do your due diligence as well. 

You Can Begin With a Small Amount

You can open a 529 account for as little as $10 in some states. But you should confirm the opening contribution amount with your state. In general, the opening of these accounts has a low investment threshold.

This is quite appealing if you are in the early phases of your career and you have a tight budget. So you don’t have to worry about having a large lump sum to get a head start on investing for your children’s future. 

529 Plans Can be Used for More Than a 4-Year Degree

529 plans not only offer low (or no) fees and low entry thresholds, the funds can also be used to fund other types of education outside of the traditional 4-year degree. These 529 plans can be used to pay for post-secondary education in technical schools, 2-year colleges, or even graduate studies. 

A recent change to the 529 plan also allows you to use the money you have saved for private education at the elementary and/or secondary levels. You can use up to $10,000 per year towards private school. It can also be used towards a religious or non-religious school, as long as it is for K-12 tuition alone. Currently, there are more than 4,000 institutions that qualify as eligible for coverage by your 529 plan. 

Friends and Family Can Contribute to a 529 Plan

More than likely your children have many doting grandparents, aunts, uncles, cousins, and family friends who love to give them gifts. But the latest toy will get old and your child will forget all about it. 

If your loved ones ever ask you for your opinion about a gift, why don’t you encourage them to contribute to your child’s 529 plan? Those $25 deposits every year will add up over time. Furthermore, several large retailers offer gift cards that can be used to contribute to a 529 plan. 

Having family and friends contribute to your child’s 529 plan is a wonderful way to get everyone involved in his/her journey to college. 

A 529 Plan Never Expires

A great feature about a 529 plan is that it never expires. Worried that a child won’t go to college? No problem. What if your child gets a scholarship? Then the withdrawal penalty would be waived. 

You can also change the beneficiary on a 529 plan to your child’s sibling. Or you can use the funds for your college expenses. Better yet, you can save it all for your grandchildren. 

Even if no one in your family uses the 529 funds, you can still access them. Although you would need to pay a 10% penalty on earnings in the account plus income taxes, this could be a minimal amount compared to compounded balance. 

Disadvantages of a 529 Plan

Some of the disadvantages of a 529 plan include:

Funds Can Only be Used for Qualified Educational Expenses

IRS allows 529 plans to be tax-deferred because they expect that the funds will be paid to US educational institutions. And that is why they require that the funds be used strictly for educational purposes. 

Renting off-campus is allowed but it only covers the individual’s room and board allowance as per the educational institution’s financial estimates. Books are covered, but non-required study guides are not covered. Food expenses are also allowed, but only up to the threshold indicated by the institution’s estimates. 

So if you choose to use your 529 funds on unapproved expenses, you will need to pay penalties and income taxes. Therefore, you need to ensure that you use the funds appropriately. 

Increased Risk

A 529 plan comes with some risks – just like any other investment. If you have a longer investment window (meaning you have some time before your child goes off to college), then this may not be a major issue. However, a bad year (or two) can erode a decade of consistent growth.

529 plans offer several options and some plans follow an aggressive growth path which is also riskier. As with every investment, the flip side to impressive gains is the downside risk and you must be prepared to manage the latter. 

There are Penalties

While a 529 plan is a good way to save for college, not using the money saved in it for its intended purpose attracts severe penalties. If you fail to use the funds in your 529 plan for qualified educational expenses, then you have to pay a 10% excise tax penalty and the applicable income tax on the earnings. 

However, there’s another issue. The regulations that govern the CSS Profile for financial aid (for private universities) or the well-known FAFSA (for state universities) have income restrictions. There is a penalty that is imposed against other available financial aid and that is currently 5.24% of the aid amount.  So your 529 savings can reduce the amount of financial aid that your child can receive. 

But the truth is that the penalty may exceed 5.24% since you have limited resources and human influencers to navigate within the financial aid process. There is no way to know for sure how much financial aid could be allocated away from your child to another student because of your 529 savings. 

Restricted to US Educational Institutions

Your 529 plan can only be used to fund your college education within the USA. The IRS will not allow you to use these funds to pay for overseas education. 

The 529 regulatory framework only recognizes US educational institutions. So if your daughter or son wants to study overseas, you will need to transfer the 529 plan to another close family member (like a sibling) or yourself. 

Pros and Cons of Life Insurance to Save for College

Let’s discuss the pros and cons of life insurance as a savings vehicle

You can also use a permanent (whole) life insurance policy to save for your child’s college expenses. You can borrow against your death benefit to pay for these expenditures. When you choose to do this, then you can either pay it back or have your agent simply deduct the amount you need to withdraw from the death payout. 

Furthermore, your whole life insurance policy may have accumulated a cash value – it all depends on how long you’ve had the policy. 

However, you also need to consider the pros and cons.

Advantages of a Life Insurance Policy

Let’s look at some of the advantages of using a life insurance policy to fund your child’s college:

Guaranteed Cash Value

A whole life insurance policy consists of both the insurance section (funded by your premiums) and the cash value. This cash value steadily grows with minimum guarantees every year but these guarantees are often low and hover around 3-4%.

Also, mutual companies pay dividends in addition to the guaranteed rate. So this gives you the minimum guarantee plus an extra 2-3%.

Tax Advantages 

Permanent life insurance policies are funded with after-tax dollars and the cash value portion grows tax-deferred. You can withdraw your basis (the sum of your paid-in premiums) without paying any taxes since the policy is funded with after-tax dollars. 

However, many people take out policy loans to borrow against their cash value. In such cases, the cash value serves as the loan collateral and the interest charged is equal to the amount they credited (which is like a zero percent rate). 

Fewer Contribution Restrictions

There are limits on how much cash value you can have, but this is tied to the level of your insurance and your contribution schedule. Although, when it comes to saving for college, the limits for paid-up additions far exceed the costs of an Ivy League degree. Contribution limits also come into play when parents are trying to catch up late in the lives of the future college attendees. 

While saving is hampered by the upfront administrative costs, the paid-up additions compensate. The latter helps you to use your life insurance policy to quickly save for college expenses. Also, the more time you have to save, the more time your cash value has to grow. 

No Impact on Financial Aid Calculations

Your life insurance cash value is not considered if your child applies for financial aid. Even if you have more than $100,000 in cash value, it still won’t be considered as income and it will not affect your child’s financial aid eligibility. You never have to list any life insurance cash value on a FAFSA application and that’s a great advantage. 

This is not the case for other college savings accounts though. If you have over $100,000 in a bank account, a 529 plan, stocks, mutual funds, etc., those funds count against your child’s financial aid eligibility. 

Furthermore, your child would likely be blocked from grants like Pell, PESOG, and TEACH. Also, it could adversely affect his/her merit/athletic scholarships, work-study programs, and military grants and scholarships. 

Can be Used for International Education 

While the 529 plan is restricted to fund college expenses in US educational expenses, this is not the case with your whole life insurance policy. 

Your permanent life insurance policy can fund college expenses worldwide. Also, your child is not at all restricted in their choice of institution. 

Greater Flexibility 

The funds inside your whole life insurance policy can be used for whatever you want when you want. 

Unlike a 529 plan, there are no early withdrawal penalties, distribution guidelines, and zero need to worry about qualifying expenses. 

The cash value is all yours – you choose what happens with your money. 

There Are No Issues if Your Child Doesn’t Go to College

A 529 plan levies penalties if the funds are withdrawn and used for non-qualifying or non-educational expenses. However, with a whole life insurance policy, you don’t have to worry about not using it for educational expenses and incurring any charges. 

Disadvantages of a Life Insurance Policy 

Now let’s talk about the disadvantages:

You Need to Qualify

Getting a permanent life insurance policy means qualifying for life insurance by taking a medical exam or answering a questionnaire. Also, purchasing life insurance can be expensive, but you also get a guaranteed death benefit. 

If you have significant health risks, then getting a whole life insurance policy to save for college may be too costly. But if you are in great shape and have few health risks, then a life insurance policy may be a good choice. 

Building Value

A cash value is a useful aspect of a whole life insurance policy. However, it takes some time to build the cash value that you can borrow against for future college expenses. 

Extra Costs

A whole life insurance policy is a combination of an insurance policy and a cash value. However, this policy can cost more than getting a 529 plan – depending on your choices. Remember that you are getting the necessary insurance plus the college savings account as an extra benefit. And the longer you keep your whole life insurance policy, the more valuable it becomes. 

While it’s great to have a cash value for college expenses, bear in mind that you’ll need to pay fees to withdraw it. You could also face a tax penalty to withdraw from your policy before age 59½. So it may be better to borrow against the cash value of your policy. 

Should I Get a 529 Plan or an Insurance Policy?

Your choice of college savings vehicle depends on your financial goals and obligations, as well as your degree of flexibility. A 529 plan allows you to focus on saving for future college expenses. Life insurance protects your family in the long-run, but some policies offer the flexibility to withdraw your funds to pay for items like loans and college costs. 

Here are some factors that you should consider to make an informed decision:

Income Restrictions

There are no income restrictions if you choose to save in a 529 plan. However, if you choose to use a life insurance policy instead, you will need to qualify for coverage, and that means supplying proof of income and other earnings to the insurer. This will affect how much coverage you are given. 

Contributions

A life insurance policy will require that you pay a monthly premium that’s set by your insurance company. This rate will be influenced by your age, gender, health, family medical history, occupation, and lifestyle. Furthermore, permanent policies (the type that allows you to accumulate cash value) tend to be quite expensive. 

However, 529 plans allow you to contribute up to the cost of education or the limits set by the state that governs your particular 529 plan. As of 2018, you can make an annual contribution of up to $15,000 per donor to an individual without paying the gift tax. So a married couple can donate up to $30,000 per year as a gift to someone else, which is a great way to fund college expenses. 

Tax Breaks

Even though your life insurance premiums and contributions are not tax-deductible, both your 529 plans and permanent life insurance policies grow tax-free. However, your 529 plan has a unique advantage in addition to federal tax savings. More than 30 states get a state tax deduction per parent. 

Interest Earnings

Both 529 plans and permanent life insurance policies earn interest over time. However, before you choose an option, learn more about the company’s investment strategy, risk profile, and recent performance.

Returns on Investment

While there are no guaranteed returns on your 529 plan, there are also no limits on these returns. However, the returns on your life insurance policy depend on its type. For example, universal life insurance policies are often tied to a market index (such as Standard and Poor 500) and may have a cap on earnings. 

Ease of Access to Funds

A 529 plan lets you withdraw tax-free only when the funds are used to pay for qualified education expenses. These qualified categories include payments for tuition, fees, books, supplies, computers, and in some instances, room and board at colleges, universities, trade, and vocational schools. A 529 plan is an investment account with a specific purpose. The funds can also be transferred across states once every year and also change your beneficiary to another qualifying family member twice per year. 

However, your life insurance policy’s cash value is more accessible and easy to use for all expense categories. Funds from your life insurance policy can be used to pay for living expenses on and off-campus and for non-college expenses like buying a car. 

Cash Withdrawals

You can withdraw cash from your 529 plan and permanent life insurance policy but there are limits to these cash withdrawals. If you use funds from a 529 plan to pay for non-qualified expenses, then you will need to pay federal income taxes and a 10% penalty on earnings.

If you get a loan against your life insurance policy, you will not face similar tax penalties. However, these cash withdrawals will reduce the death benefits that your beneficiaries will receive. You may also need to pay interest. 

Ease of Maintenance 

Both the 529 plan and permanent life insurance policy are quite low-maintenance. Once these accounts are established, you can set up auto-pay to fund them. Furthermore, universal life policies allow you to adjust your premium payments according to your financial situation. 

Fees

While both accounts attract fees, 529 plans tend to have lower fees. The administrative and advisory costs can range from 0.25% to 1.85% plus broker fees for 529 plans. However, the charges on cash value insurance policies often linger around 2% due to commissions. 

Financial Aid

Your 529 plan is considered a financial asset and it can affect your child’s financial aid eligibility by up to 5.64%. If the student owns that plan, then that rate increases to 20%. If your college savings plan relies a lot on financial aid, then carefully consider the 529 option. However, life insurance policies are not seen as financial assets and are not included in financial aid calculations. 

Can I Purchase a Life Insurance Policy and Also Invest in a 529 Plan?

Having a 529 plan and a permanent life insurance policy can help you save for college

You can use a 529 plan and a permanent life insurance policy in tandem to save for higher education expenses. Your 529 plan allows you to save strictly for education expenses while life insurance policies help you to cover education and non-education expenses. So having both options will be most beneficial if you have financial obligations outside of college costs.

A life insurance policy gives your family the future financial security they need. Also, upon your passing, your beneficiaries can use the death benefit to cover college expenses. A 529 plan is a popular way to save for college. However, all investment products have their limitations, so you need to do your research and compare the pros and cons of every available option. 

Other Considerations

You should also think about the following before deciding:

Do You Need Quick and Large Returns to Fund the Cost of Tuition?

If you need large returns, then a 529 plan is a better option. As with 401(k)s, you can choose from many investment vehicles such as stocks and bonds. You can also select the level of risk you prefer. Permanent life insurance policies provide guaranteed returns, which are good for lifetime security but are not suitable for short-term financial goals. 

Do You Need Easy Access to Withdraw Cash?

A 529 plan allows you to withdraw as much cash as needed to pay for qualified college expenses. However, the cash value in your insurance policy must get to a certain level before you can start making withdrawals. This level is set by the respective insurance companies and could take several years. 

What if Your Child Doesn’t Attend College?

Are you worried that your child will not go to college? Then you may consider a life insurance policy instead. You can easily use the cash value in your insurance policy to pay for things other than education. However, if you choose to cash out your 529 plan (if your child doesn’t go to college), you will need to pay federal income taxes and a 10% penalty on earnings.

What if Your Child Wants to Study Abroad?

The funds in a 529 plan are primarily used for educational institutions that are accredited by the US Department of Education. However, you can also use these funds to pay for study abroad programs at overseas approved institutions.

What Happens if Your Child Gets a Scholarship?

If you have a 529 plan, then the 10% penalty is waived, but you will need to pay federal income taxes on those funds. If you have a life insurance policy, you can easily reroute the cash value to pay for other things – such as a deposit on a home. 

Do You Need to Save Money for Other Types of Schooling?

Do you have more than one child of school age? Then a 529 plan is ideal as you can use the funds to pay for elementary and secondary education. However, the 529 option only allows you to withdraw up to $10,000 per year for K-12 tuition, so if you need to spend more per annum, then a life insurance policy would be a better fit. 

Riegelwood Federal Credit Union: Your Partner in Planning for the Future

So 529 plan vs. life insurance policy? You choose which vehicle to use in saving for future college expenses. The best savings strategy is the one suitable for your finances and unique goals. Riegelwood Federal Credit Union is your choice to save for your higher education expenses. We invite you to contact us today to get our expert assistance in planning for your future.