Funding a College Education with Life Insurance

There is no question that a college education is expensive. The best way for a parent to help their child pay for college, without either the parent or child having to go deeply into debt with loans, is to start saving early. Here early means the younger the better. Thanks to compound interest, the longer the period over which you save, the more the savings grow with the compounding of interest. Also, the longer the period in which you contribute the smaller the incremental payments.

Do the math. Assuming no interest, if you were to calculate that $40,000 will be needed for college and you begin putting money away monthly two years before the child starts college you will have to sock away $1,666.67 per month for 24 months. However, if you start 18 years before the start of college you only have to save $185.19. Both of these numbers assume no interest. If you factor in the interest that the savings will earn, the monthly payment will be less. Again, the longer the period, the greater the impact of the interest, so the sooner you start the less you will have to contribute each month to reach your goal.

However, a problem arises when you use the longer time frame and rely on interest, and this is taxes. Interest is income and income is subject to both Federal and State income taxes (and local income taxes if you live in a city with an income tax). As the fund grows, the interest becomes significant and so does your tax liability. You then have a choice, either pay the tax with funds from current pay or withdraw some of the interest to pay the taxes. Regardless of whether you pay the tax with current income or withdraw funds from the college savings the result is the same – namely the total amount being paid for savings and taxes is greater than if you were just saving the money.

There are some ways around this tax problem and these include:

• Savings accounts in the child's name, under the Uniform Gift to Minors Act. Due to children usually having little or no income other than the savings, the taxes are either avoided or are very low.

• 529 State sponsored College Plans (but offered by private investment companies) are investment plans that provide Federal income tax and sometimes state income tax advantages as well, but have other restrictions.

• Coverdell Plans – these are the so called education IRAs and they also provide Federal Income tax sheltering but have other restrictions.

• Life insurance coverage for the child.

A problem with savings accounts under the Uniform Gift to Minors Act is that the money belongs to the child. Once the child reaches 18 the money is their's to do with as they please. Before age 18 the parents can withdraw it but they have to show that it is being used for the child (in addition to justifying your action to the IRS the child could potentially sue you in later years as well for misappropriation of their money). 529 and Coverdell Plans also have restrictions on the use of money other than for college and there are stiff tax penalties for using the funds for other than college.

Life insurance on the child gives a parent both tax sheltering and flexibility in the use of the funds. There are three parties to a life insurance contract: the insured, the owner and the beneficiary. When the child is born the parents take out a policy on the child. Assuming the child is healthy, the parents can purchase a very large policy for a relatively low premium payment. The child is the insured but the parents are the owners. The parents will probably also make themselves the beneficiaries. As payments are made cash builds up in the cash portion of the policy. Investment income generated by the cash portion of the policy further increases the balance. Under current tax laws, the investment income generated by life insurance policies is not subject to income taxes, so the cash value grows tax free. When the child is ready for college the parents can cancel the policy and withdraw the cash value or keep the policy and borrow the cash value at a low interest rate to pay for college. If the child decides not to go to college the parents, as owners of the policy, can keep the money in the policy or withdraw it and use it for something else. At some point the parents may want to transfer ownership of the policy to the child but they are not required to do so.

The downside of life insurance are the commissions and cost of the insurance portion of the contract which reduces the amount of the monthly premium that goes into the cash value portion of the account. This has the effect of reducing the investment return on the cash value. This is the cost incurred for the greater flexibility. However, eighteen years is a long time and things can change so there are benefits to flexibility. Funds can legally be withdrawn without tax penalty to pay for family emergencies not directly related to the insured child (such as paying the mortgage when you lose your job). Also, if your child turns out to be the next Bill Gates (who never completed college) and writes a hot computer program at 16 and needs funds to launch her company, you can use the money from the life insurance for that purpose.

Life insurance on a child is not for everyone. However, it is one option that can be considered when planning for your child's college education.