Cash Value Life Insurance: A Unique College Savings Tool

April 15, 2011

Brian A Jackson / Shutterstock
Brian A Jackson / Shutterstock

When you think about saving money for college tuition, what comes to mind? Savings accounts, CD’s, money markets, and maybe even stock investments. I would safely bet that life insurance is not one of the ways the typical parent funds his or her child’s tuition. However, consider for a few moments that life insurance, specifically cash value life insurance, can be a helpful tool in preparing for what can potentially be one of the largest expenses of your lifetime: college tuition.

How can cash value life insurance be used to fund your child’s or grandchild’s college education?

The purpose of life insurance is to provide a sum of money (the death benefit) at the death of the insured. When you use life insurance as part of your college-funding plan, you can provide funding for your child’s college education in two ways. The first, and perhaps obvious, use is the death benefit, which can be used to pay for your child’s college education should you die prematurely. Statistically speaking, you probably will be alive to see your child through college, in which case you can still use life insurance as part of your education-funding plan. When you choose a cash value life insurance policy, you have a second way of reaching your college-funding goal. When you pay premiums on a cash value policy, some of your money is applied towards the policy cash value, making it sort of a savings account within the life insurance policy. Cash values accumulate and can be used during your lifetime via withdrawals and/or policy loans. For the purposes of this article, we will assume that you will live beyond the time your child enters college, and we will focus on the potential benefits of using cash value life insurance in your plan for funding your child’s college tuition.

Timing Your Purchase of Life Insurance

Life insurance can be an important tool in your savings plan for your child or grandchild’s college education. However, it is not appropriate that you buy life insurance solely for funding college tuition. You should only consider life insurance for this purpose when you also have a need for life insurance protection. Need is determined by several factors. If you work and produce an income that your family depends on, there is likely an insurance need. Even if you don’t work outside the home but are responsible for the care of your children, there may be an insurance need.

Insurance companies often charge the policy expenses, such as fees and commissions, in the earlier years of the policy. Because of this expense front-loading, several years could pass before your policy cash values begin to accumulate to sizable amounts. It is generally recommended that cash value insurance be considered for purchase when you intend to hold it for a long period of time, usually at least 10 or 15 years.

Advantages of Cash Value Life Insurance

Unlike other investments or a savings account, life insurance provides your family with a death benefit. Generally, the amount of the death benefit is significantly larger than the total premiums paid for the policy. If you should die before your child enters college, tuition can be paid from the policy death benefit. Should you live (which is much more likely), you can use policy cash values to pay for some or all of your child’s tuition. Your family still receives the benefit of life insurance as long as the policy remains in force.

The portion of your premium payment that is applied to cash value is invested either by the insurance company or at your direction, depending on the type of policy. Positive investment returns increase the cash value. You are not subject to taxes on the growth in cash value until you withdraw the cash values or cancel (surrender) the policy. It is possible that you may be able to withdraw cash values and not be subject to income tax on the withdrawal.

When the time to pay college tuition arrives (or you need the money for any other purpose), you might withdraw some or all of the cash value from your policy, much like a withdrawal from a bank account. The amount you can withdraw is generally limited to a percentage of the cash value and varies by policy and company. You may be able to withdraw from your cash value and still keep your insurance in effect to provide a death benefit at your death.  It is a good idea to leave enough cash value in the policy to maintain the policy and cover the policy fees.

Cash values can also be accessed by using a policy loan. Policy loans are allowed under the terms of your insurance contract and are not affected by your current financial position. In other words, you do not have to undergo a credit check or a bank loan approval process for a policy loan. When you take a policy loan, the check you receive comes out of the general funds of the insurance company, not your cash value. Your policy cash value serves as the loan collateral. The interest rate for a policy loan is known in advance and may be lower than that on a bank loan.

Some policies allow borrowings at an interest rate only slightly higher than the rate being credited to cash values. With some policies, the loan interest rate charged equals the rate credited to cash values, for a zero net cost loan.

If either your dividends or the increases in cash value are reduced, this is also part of your cost to borrow.  If you die with an outstanding policy loan against your account, your death benefit is reduced by the amount of the outstanding loan balance.  Interest accrues on the unpaid loan balance. If you choose not to repay the loan, the accruing interest could erode your cash values and result in a policy lapse with some types of policies.

Cash value withdrawals and policy loans are not exclusive events. You can use a combination of withdrawals and loans to maximize the tax-free cash withdrawal benefits. You might choose to make cash value withdrawals up to the amount of your policy basis and then take a policy loan. In insurance terms, this is referred to as “surrender to basis and switch to loan.”

Example: Let’s say you have a son you are putting through college. You own a cash value policy that you bought just after he was born, and you are considering accessing your cash values to pay this year’s tuition. The first thing you might do is to make a tax-free withdrawal of cash value from the policy equivalent to the amount of premiums you have paid into the policy. After you withdraw to your basis, you take a policy loan.

Tradeoffs of Using Life Insurance

In order to get life insurance, you must be considered insurable by an insurance company. Insurability can be affected by such factors as medical history, age, or participation in dangerous hobbies such as auto racing. Life insurance is not available to people in extremely poor health, although few people are actually refused insurance.

Even if you have a history of health problems, you may still be able to buy a rated policy. In a rated policy, the premiums are higher than in a preferred policy (whose favorable premiums reflect the fact that the applicant is less likely to die than a standard applicant), but your need for insurance protection may make it worth the expense.

Once you buy a life insurance policy, there is often an ongoing expense: the premiums. In the early years of the policy, the premiums represent a contractual obligation. Obviously, when you pay premiums, you have less cash available for other purposes.

What factors should you consider when choosing a policy?

When planning for college expenses, parents are often concerned with four areas: tax benefits, financial aid, control issues, and investment costs. Generally, all types of cash value life insurance will provide you with the same benefits in the areas of tax benefits and financial aid. The major difference between various policy types occurs in the areas of control and costs. The following types of life insurance all contain cash value and may be used for funding your child’s college education.

– Whole life

– Variable life

– Universal life

– Variable universal life

The following tax characteristics are common to all types of cash value life insurance.

– Cash value grows tax deferred

– Cash value withdrawals to basis are not taxable

– Death benefit is generally received by beneficiary free from income tax

Some assets, like cash value life insurance, may be treated differently, depending on who is doing the financial analysis, the government or a college.

Federal financial aid calculation methodology does not include policy cash values in parents’ total assets when determining a child’s financial need.

 

Individual colleges may consider policy cash values when determining a child’s financial need.

In all cases, when you own a cash value life insurance policy, you control the policy. You can decide if withdrawals are to be taken, when allowed under your policy, or if you want to take a policy loan. You choose the policy beneficiary (who will receive the death benefit when you die). However, between the various types of cash value policies, there are differing levels of control over the cash value investments and premium payments. These may be key factors in choosing the appropriate life insurance type for saving for your child’s college education, while also protecting your family’s income at your death.

All life insurance policies require some payment of premium. However, depending on the policy you choose, you may be able to control the timing and amount of your premium payments. You might want to budget a fixed amount that is due on a specified date (e.g. monthly or annual payments). On the other hand, you may want the flexibility to decide if you will occasionally pay a larger or smaller premium or skip a payment altogether. You may want to pay your premium in an up-front lump sum, thereby eliminating future payments.

What are the tax implications?

Life insurance premium payments are not tax-deductible expenses.

Life insurance policy cash value withdrawals are considered a non-taxable recovery of your policy basis until the entire policy basis has been withdrawn. There are special rules for policies that are classified as a modified endowment contract (MEC), which are not discussed here.

Say you own a life insurance policy (non-MEC) with a cash value of $15,000. Your basis in the policy equals $12,500. You plan to take a withdrawal of $7,000 now to pay for part of your son’s tuition. You won’t have to pay tax on this withdrawal amount because it will be considered a return of your basis.  Withdrawals in excess of your basis are treated as taxable distributions of interest or gain.

When you take out a loan against your life insurance policy (except a MEC), the amount you receive is not considered taxable income. This rule applies even when the loan is larger than the amount of premiums you have paid in.

Say you own a life insurance policy with a cash value of $20,000. Your basis in the policy is $17,000. You decide to take a policy loan to pay for your daughter’s tuition. Under the terms of your policy, you are allowed to take a loan for an amount up to 90 percent of the policy cash value–in this case, $18,000 ($20,000 x.90). You are not subject to tax on the amount of the loan, even though the loan is larger than your basis.

If you cancel (surrender) your policy for cash, the gain on the policy is subject to federal income tax. The gain on a canceled policy is the difference between (1) the net cash value and any loan forgiveness amounts, and (2) your policy basis.

Policy death benefits are generally not subject to federal income tax.  When the proceeds of your life insurance policy are paid to a beneficiary other than yourself (as the owner-insured) or your estate, they are not treated as a gift for gift tax purposes.

There are many uses for cash value life insurance and many good reasons to consider whether these products are right for you.  However, it is important that you work with an experienced life insurance agent who truly understands how they work and how they can best meet your financial needs.

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