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How to Use a Life Insurance Policy to Save for College

Updated on July 7, 2017

Provides Tax Sheltering of Investment Income as well as Flexibility for Parents

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. Early as used here 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.

Taxes can Eat into Your College Savings

While a longer time frame with interest results in lower incremental payments, a problem arises and this is income taxes on the interest earned. .

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 without interest.

Ways to Legally Avoid Taxes on Colege Savings

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, children, who usually have little or no income other than the savings, the taxes are either avoided or are very low.
  • 529 State sponsored College Plans These are are investment plans, offered by private investment firms, 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 also have other restrictions.
  • Whole 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 having to justify your action to the IRS, your child could potentially sue you in later years for misappropriation of their money.

529 and Coverdell Plans also have restrictions on the use of money for purposes other than for college and there are stiff tax penalties for using the funds for other than college.

Retaining Control of Funds and Avoiding Taxes with Whole Life Insurance

Whole Life Insurance is a type of life insurance that has both an insurance and a savings component. When used to insure one's child a whole life insurance policy gives parents a way to both shelter the income earned on the savings portion of the policy as well as giving the parents control over how the funds in the savings part of the policy are used.

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.

When the policy is purchased the parents name the child as the insured and then name themselves as both the owners of the policy and the beneficiary on the insurance.

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 federal 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.

Advantages and Disadvantages of Using Whole Life Insurance for College Savings

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.

The monthly premium includes amounts for the agent's commission, the cost of insurance and a deposit to the cash value. This has the effect of reducing the investment return on the cash value as only part of the payment is deposited in the cash value portion of the policy.

When considering using whole life insurance as your vehicle for college savings, you have to consider the fact that only a portion of each month's payment goes to your child's college savings.

In effect, the portion of the monthly payment going to agent's commission and the purchase of insurance is the cost incurred for the greater control and flexibility you have with this type of plan.

In making the decision to use or not use whole life insurance as your college savings vehicle you have to consider the fact that 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 if 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 age 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.

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    • Chuck profile imageAUTHOR

      Chuck Nugent 

      5 years ago from Tucson, Arizona

      TLJL - I agree with what you said about whole life insurance as an insurance policy. In my opinion, this is not a good investment for most people as the return is not that great on the cash portion of the policy and term insurance can provide the same amount of insurance coverage at a much lower cost.

      However, my point in this Hub was to show people a way to set up a college savings plan for a child that would accomplish three things.

      First, the savings (the cash accumulation portion of the policy) would grow tax free.

      Second, the insurance portion of the policy would guarantee the full amount for college in the event the parent or other person providing the funds for college dies before the child reaches college age.

      Third, as the owner of the policy, the parent or other person doing the saving for the child's college education has control of the funds and can use the accumulated cash value in the event that the child decides not to go to college or enters college and decides to party rather than go to class and study.

      As I mentioned in the Hub there are other options such as 529B and Coverdell plans or a savings account in the child's name which can shelter the interest earnings on the savings from taxes but don't leave the person doing the saving with control or provide the insurance guarantee.

      Like any other financial tool, one size does not fit all, so depending upon a person's objectives, using whole life insurance may prove to be the best option.

    • TLJL profile image

      TLJL 

      5 years ago

      Whole life policies are a very expensive way to go for most families. Families should clearly understand that the cash value is part of the death benefit. You do not get both and you are borrowing from yourself. Generally, the insurance company gets the interest on the money you are loaning yourself. Cover them and parents as well with term life and invest the difference in other more lucrative savings / tax shelters.

    • profile image

      Imelda Ross 

      7 years ago

      i have been homeschooling my kids for sometime now and i have been having talks from close friends for a proper college education. i am satisfied with my how my kids are even though they are homeschooled. and i watch them liking every minute of the experience.

      thanks for this hub though. i never thought funding college education through insurance is possible.

    • profile image

      cancer health insurance 

      7 years ago

      Nicely done, I loved the hub.. I am bookmarking it..

    • g1pkn profile image

      g1pkn 

      7 years ago

      A great hub, following on from this, I would consider thinking about putting your life insurance into trust as this will guarantee should you have a pay out on the plan that it goes to who you want it to ...... https://hubpages.com/money/Should-I-Put-My-Life-In...

    • jennifercriston profile image

      jennifercriston 

      7 years ago from Oxford Road

      Nice hub..

    • profile image

      Real Insurance 

      7 years ago

      This is really great information especially for new parents who are thinking about what they can do now to start preparing for when their kids go to college. Most parents in this situation would think about starting a savings account but would never think about starting a life insurance policy for the child as a plan for college. You've accurately described exactly why this is a good idea. Great job!

    • yyn1221 profile image

      yyn1221 

      8 years ago from China

      if you borrow money from your life insurance policy you can pay yourself back or have your child pay you back, depending on your philosophy. So in essence you have recaptured the principal and interest you would otherwise have paid someone else's bank. If you choose the correctly designed policy that offers 60 to 70% cash value immediately and buys more paid up additions with the tax free dividends and tax deferred interest growth and the interest spread from paying yourself back, you increase the death benefit, which in turn increases the dividends you earn which in turn increases the amount of cash value available to you to continue banking with.

    • DrewberryMortgage profile image

      DrewberryMortgage 

      8 years ago from London

      This is a really good idea, I'm going to share this with my colleagues. Thanks.

    • Jennifer Bhala profile image

      Jennifer Bhala 

      8 years ago from Upstate New York

      It is an excellent idea to use whole life insurance to fund not just higher education but also any item or event you would otherwise borrow money to purchase. This is one reason why; if you borrow money from your life insurance policy you can pay yourself back or have your child pay you back, depending on your philosophy. So in essence you have recaptured the principal and interest you would otherwise have paid someone else's bank. If you choose the correctly designed policy that offers 60 to 70% cash value immediately and buys more paid up additions with the tax free dividends and tax deferred interest growth and the interest spread from paying yourself back, you increase the death benefit, which in turn increases the dividends you earn which in turn increases the amount of cash value available to you to continue banking with. When you borrow money from someone else's bank you give them all your money and interest and that money has gone, it has flowed away from you. You can reverse the flow of your money using the correct life insurance policy and understanding how to apply different banking strategies that increase your wealth exponentially.

      You can be in control of your money. You can have penalty free access to your money. You can have use of your money for what ever you decide. No other financial vehicle offers all the advantages of specially designed for banking life insurance policies.

    • profile image

      Insurance 

      8 years ago

      One of great article about life insurance I read today

    • mr.khan profile image

      mr.khan 

      8 years ago

      What an article you published..I like it very much and i agree with you..I suggest you a website http://www.Insurance-info.page.tl..please visit and tell me

    • Chuck profile imageAUTHOR

      Chuck Nugent 

      8 years ago from Tucson, Arizona

      insurance bodies - thanks for your comment.

      I agree with you in general but, as I pointed out in the Hub, there can be some advantages to doing it this way. Like everything else in life there is no "one size fits all solution" to most things in life.

    • profile image

      insurance bodies 

      8 years ago

      Am not an advocate of using an insurance policy to fund college education for your kids because its very expensive to maintain. it would be preferable to use •529 State sponsored College Plans.If you want insurance buy insurance but if you want to prepare for childs college do it.

    • profile image

      scheng1 

      8 years ago

      good idea. Actually parents and children must buy insurance. If parents die young, at least children can inherit the insurance payout

    • profile image

      Matt 

      9 years ago

      Good information - but keep in mind that while custodial savings accounts and section 529 savings plans provide some tax advantages, they also will count as assets owned by the family and can have a negative impact on financial aid elibibility - especially at private colleges. The tax savings may seem small compared to the financial aid lost as a result of saving in the wrong pocket. Roth IRAs and/or more specialized, liquid life insurance policies might be better options for people.

    • profile image

      bzweig 

      10 years ago

      I'm sure that your readers would like to know that a popular website

      www.529andmore.com is a resource for information on 529 plans. The site

      also provides an approach for funding higher education utilizing a unique patent-pending life insurance

      policy from which the funding to pay for college can come while the insured is alive.

    • raymondphilippe profile image

      Raymond Philippe 

      11 years ago from The Netherlands

      You can't start early enough making reservations for your kids future education!

    • Chuck profile imageAUTHOR

      Chuck Nugent 

      11 years ago from Tucson, Arizona

      Thanks for the comment, Paul. You are right each state sponsors their own programs. However, everything I have learned about these (and there is still much I don't know) individuals can participate in these programs regardless of whether or not the program selected is sponsored by their state. In some states there are tax advantages, with regard to state income taxes, if you choose a program sponsored by that state. However, this is not true of every state.

    • Paul Edmondson profile image

      Paul Edmondson 

      11 years ago from Burlingame, CA

      This is a great article. We started 529B programs when each girl was born. One of the things I found challenging was selecting a 529 program since each state offers their own.

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