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Saving For College - Life Insurance, 529 Plan or Roth IRA?


How you chose to fund your child’s education could impact his or her ability to attend college almost as much as the grades they achieve. Section 529 plans are the college savings vehicle that I am most frequently asked about. This is not surprising as they offer federal and sometimes state tax benefits. They also subtract far less from a student's financial aid package than money stored in a checking or savings account. But having a large 529 college savings plan can actually hurt the student's chances at tapping other sources like financial aid. This has some parents seeking other avenues of saving, such as cash value life insurance policies. These policies may not offer the state tax incentives of a 529, but they have fewer restrictions on distributions, can offer some tax advantages and can shelter funds from hurting ones chances of financial aid. Let’s examine further.

Flexibility

  • 529 plan – Can be used for qualified education expenses only. This includes tuition, fees, books, and room and board at an “accredited” U.S. school. Should your child receive a full scholarship, not attend college (a concern I often hear) or choose an unaccredited school you have two options. Either transfer 529 funds to another beneficiary or cash in the 529 plan. If you cash in the plan, you would pay income tax and a 10% penalty on the gain within the account. You may also have to back taxes if you've taken state tax deductions on the contributions.

  • Life insurance - No requirement with how you use the money. You can take withdrawals and/or a loan for any purpose, including all college expenses. A student can use life insurance savings for college, a down payment on a house, to start a business or for retirement.

Risk

  • 529 plan – Carries market risk. The custodian (you) chose from the investment options available within the 529 providers plan. It is a set menu and options range from conservative to aggressive. I can help with deciding how to invest the funds.

  • Life insurance – Whole and universal insurance policies frequently provide guaranteed returns. However, in the first two years of a life insurance policy you're getting a minimal of rate of return because insurance providers are pulling out the costs. After 5+ years you typically see a higher rate of return. Contact me for a quote to see the exact numbers. The policy can be constructed to address your budget and needs.

Impact On Financial Aid

  • 529 Plan – 529 assets will impact financial aid. Assets in accounts owned by a dependent student or one of their parents are considered parental assets. When a school calculates the student's Expected Family Contribution (EFC), a maximum of 5.64% of parental assets are counted. So 10k in a 529 increases your EFC up to $564.

  • Life Insurance – Not counted as an available asset in the financial-aid calculation. However, a withdrawal from the cash-value part of the policy is treated as a form of income and will count against financial aid the following year. Taking a loan against a life insurance policy should not count against your financial aid but will reduce the death benefit of the policy.

Cost Considerations

  • 529 Plan – Is usually less expensive. Management expenses are in the arena of 1% annually on the funds invested, but this can vary. A 529 can provide a potential tax deduction on the contribution, but not every state offers one and most that do only offer it to residents invested in the state’s plan.

  • Life Insurance – Is likely to be more expensive. Cash value insurance policies can easily be in excess of 2% annually. One would typically insure the student vs. the parent or guardian. Insuring the student can help reduce the expenses.

But wait, what about the Roth IRA???

The hidden gem….like life insurance, money invested in a Roth IRA grows tax-free and contributions (only contributions) may be withdrawn tax- and penalty-free if used to cover college costs. Unless you are 59 1/2 or older, then earnings may also be withdrawn tax and penalty free. Since a Roth IRA is technically for your retirement, the funds in the account have no effect on financial-aid calculations. If your child gets a scholarship or does not go to college you simply have more money for your retirement. One downside is the contributions to a Roth IRA are limited to $5,500 per year ($6,500 if age 50 or older) and income limits mean that high earners may not be eligible to make direct contributions (2017 phase out for married filing jointly is 186,000-196,000k). If you are a high earner you can attempt to use what is called a backdoor Roth IRA. This requires opening a traditional nondeductible IRA and then converting it to a Roth. You can also attempt to use an after-tax 401(k) or Roth 401(k) if your company offers one. These funds can then be potentially rolled to a Roth IRA.

There are numerous strategies one can use to fund college education and there is no golden bullet for all. Which you chose is dependent up your risk tolerance, financials and goals. I can help you decide. Contact me and I will run a cost analysis and outline the pros and cons with regard to your particular situation.

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Disclosure: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified.

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