Should I buy or invest in the life insurance or a 529 plan?
Your financial goals, obligations, and flexibility are essential elements when choosing a life insurance or 529 plan. A 529 plan helps you save for future college costs while life insurance protects you and your family. Some life insurance policies offer flexibility to withdraw funds or pay for loans and college fees.
Here are useful factors that will help in decision making:
- Income limits: For 529, there is no income limit. In life insurance, you must qualify for coverage and provide proof of income and other earnings to the provider. This helps in determining the amount of coverage that will be offered.
- Contributions: The life insurance company determines the premiums payable. The rate is dependent on age, gender, health, occupation, family medical history, and lifestyle. Permanent life coverage is quite expensive. For 529, the amount payable is dependent on you. The amount must not exceed the set limit or the cost of education. As of 2018, the maximum contribution was $15,000 per individual without being subject to the gift tax. The amount doubles to $30,000 if you are a married couple and the contributions are split.
- Tax breaks: Premiums and contributions are not tax-deductible, but both grow tax-free. A 529 offers federal tax savings, and over 30 states provide a full or partial tax credit on contributions. For example, families in New York get a state tax deduction of up to $5,000.
- Investment returns: Returns on 529 are not guaranteed, and there are no caps on returns. Returns on life insurance policy depend on the type of policy. For instance, universal life insurance is tied to a market index, like Standard & Poor 500, and has a cap on earnings.
- Interest: 529 plan and permanent life insurance policies earn interest over time. Before signing a policy, read and understand the policies, approach to risk, and recent performances.
- Flexibility with funds: a 529 plan offers tax-free withdrawals when the funds are used to pay for qualified educational expenses. The account is transferable from one state to another once a year, and you can change the beneficiary family with another qualified family twice a year. The account pays for most educational expenses starting from fees to stationery. The life insurance can only be used for expenses such as housing around campus.
- Withdrawing cash: The account holder of the 529 or policyholder of the life insurance can withdraw the money. If you withdraw funds from the 529 accounts and use it to pay for other expenses not related to education, a federal income tax and a 10% penalty on earning are charged. With the insurance policy, you face a different kind of tax if you take a loan. You may be charged interest or lower the amount beneficiaries receive.
- Fees: Both investment plans are subject to fees. For 529, administrative and advisory costs range between 0.25% and 1.85%. Insurance policies have a cash value charge of around 2%.
- Financial aid: 529 is a financial asset that can impact a student’s financial eligibility by up to 5.64%. If the student owns the plan, the rates jump to 20%. Life insurance policies are not included in financial aid calculations.
Can I buy or invest in both life insurance and a 529 plan?
Yes. Savings in the 529 plan are used for education, while life insurance policies are more flexible. Permanent life insurance cash allows you to use the cash in a manner that you wish. If you have more obligations besides education, buy both.
The life insurance policy gives financial security for the future. When premature death happens, the death benefit can be used to pay for college. The 529 is a good college savings plan.
How 529 plans work?
State-run 529 plans are like a Roth 401(k) or Roth IRA but are intended for educational and not retirement savings. You can invest in mutual funds, and earnings are tax-deferred for your 529 plan. The IRS inspects the educational expenses; hence withdrawals will be tax-free.
Most states offer tax deductions or credit for your contributions to their plans to add their appeal. There is, however, no federal deduction or credit for your contributions.
While 529 is the most preferred way for saving for college, you can take the permanent life insurance. Unlike the term life coverage, it has a tax-deferred savings component.
How permanent life insurance works?
For every dollar you pay as premiums, a portion goes toward the death benefit while the rest is held in a cash-value account. Whole life insurance is the safest form of permanent life insurance. Many policyholders expect a return of between 3% – 6% after paying some years. The amount may vary depending on how the investment performs. Meanwhile, money in the cash-value account grows tax-deferred like a 529 plan.
Variable life insurance is another form of permanent life coverage. Policyholders have some control over their investment. You select sub-accounts (mutual funds) that you want in your account. The annual return is based on how the underlying investments perform. There are greater returns and high risks on your investment.
When you have a child joining college, you can take a loan against the cash balance. If you do not pay the loan, the death balance is reduced. It can work perfectly if you intend to use the balance for college funding.
Pros of using life insurance for college
Life insurance has more benefits than the 529 plan. One is flexibility. If your child decides not to join college, earnings in the 529 are subject to ordinary income tax and a 10% penalty, but contributions are exempted. A beneficiary in a lower tax bracket can withdraw the funds. Life insurance beneficiaries do not face these taxes. In the 529 plan, you can name another beneficiary.
Life insurance is not included in financial aid calculations, while money in the 529 plan is considered a parental asset. Up to 5.64% of parental assets are counted in the applicant’s Expected Family Contribution for every year in college.
Cons of using life insurance for college
Permanent life insurance upfront and recurring fees that make stock and bonds look like a deal. Nearly 50% of first-year premiums are used for representative’s commission.
It may take up to 10 years for your cash value to surpass what you have paid in premiums. You need to start building your policy early if you intend to use it for college fees.
The heavy annual expenses weigh down your earnings. Most permanent life insurance policies charge up to 2% administrative and investment costs annually. This is different for 529 accounts. A 529 account sold directly had fees of 0.39% in 2018, according to a report by Morningstar in May 2019. Advisor-sold funds are slightly expensive and average 0.93% fees.
Is life insurance a good way to save for college?
Whole life insurance policies are perfect for saving for college if you start saving early. However, the simplicity and lower fees associated with the 529 accounts make them a better plan.
Is 529 a good idea?
A 529 account is a smart way to save for college expenses and has advantages over a standard brokerage account. You can grow your savings tax-free and get some state tax incentives for your contributions.
Can you lose money in 529?
You can not lose money in your 529 accounts. Even if the beneficiary does not need the money, it is still yours. The money can be used for post-secondary education or even for yourself.
Should I open 529 for each child?
A 529 plan only has one beneficiary. You need to open a separate account for each child. The contributions are considered gifts for tax purposes, and you can save up to $15,00 per beneficiary (in 2018) and $30,00 for couples.