High Earner? Beat the FAFSA and pay for College with Life Insurance
As both an insurance broker and financial advisor, I get to share in the joys and sorrows of person’s life much more than say, a plumber or a postman.
One of the best times for my clients are the birth of a new child – and one of my greatest joys is getting new or prospective parents to plan ahead for their child!
I’m not going to go through the statistics – I already know you know that college is very expensive, even if you want your kid attending the same in state college that you matriculated from.
What I think all of these alarmist articles miss is you do get almost 20 years to plan for this eventual expense – and that long head start combined with clever financial planning can mitigate some the shock of those costs.
Yes, I agree that college is expensive – too expensive, but it does still provide outsized benefits to those who have graduated from accredited programs, and will continue to be a core requirement of most employers going forward.
College Planning 101
The first way that you can start reduce the out of pocket costs of admission is to start putting money away now, before your child is born. There are no tax advantaged programs for this, but you can always get a head start putting away cash in a separate savings or individual investment account if you are planning or expecting a child.
Once the child is born, you are home from the hospital, and everyone is happy and healthy, no matter who you are, it’s time to start planning for college – seriously.
The earlier you start the better, because the value of compounding your money. By starting at age 2 instead of when your child was born, by college age your final balance would be about 25% less, assuming a 7.5% return on the money.
There are a number of different ways that you can pay for education, so let’s take a look at all the options:
You have probably heard of 529s before – they have been all the rage in the last 20 years. What they are is a tax advantaged program administered by state programs that you (or any relative) can put money into for your child.
529 plans are run by investment companies – once you put money into the 529 for your child, you can pick an assortment of mutual funds where the money gets invested.
More recently, the investment companies have come out with target date funds that takes all of the re-balancing and risk management off your hands – these funds are age based and become more conservative as your child gets closer to attending college.
If that money is used for education or the assorted expenses that go with it, it’s completely tax free – but if it is not, any interest or gain is taxable with an additional 10% penalty. If you took a tax deduction for contributing to the plan, the state or IRS may recapture those credits and force you to pay them out as well.
You can money from one 529 plan to another, but once it is in there, if its not used for education it will be taxed and penalized.
529 plans used to be available only for college expenses, but they can now be used for Private High School tuition, uniforms, and books too because of the passage of the 2017 Taxes cuts and jobs act signed by President Trump.
Sounds pretty good right?
Well yes and no – don’t get me wrong, I think these plans are valuable, especially for people with an income of less than $180k a year (which is most people).
A good rule is if you (or your accountant) aren’t figuring out if you owe AMT tax this year, than it’s better to stick with a 529 plan over life insurance for college funding.
As your income starts to grow above that line, or if you have an unusually large amount of assets, you are going to run into other problems – namely FAFSA.
FAFSA stands for Free Application for Federal Student Aid. It is a unified application that almost every college uses to determine eligibility for Student Aid – basically, how much will college cost you.
FAFSA actually uses a complicated set of rules based on not only your income and net worth, but also on your children’s. It takes into effect your income and assets as well as your child’s income and assets (and weighs your child’s portion more heavily – which can complicate asset transfers to them).
The FAFSA application calculates what’s called an Expected Family Contribution – and limits the potential Federal Aid you can receive if it is too high.
Colleges have for a long time now been charging more to those who can ‘afford it’. It’s like walking into Starbucks and being charged $15 dollars a drink instead of $6 because you have more money in your bank account.
The difference in a FAFSA application can be huge – if you’ve got too much money showing for either you or your child, you won’t be able to qualify for any of the discounts and could end up paying tens of thousands of dollars a year more every semester. Shielding your exposure to the FAFSA should be a top priority if you want to pay less for your children’s college
Is there any way to get around this problem besides making less money?
You know there is! – Along with limiting your income with pre-tax contributions to 401ks or SEPs, there is one financial instrument that you can store money that is not included in the FAFSA calculation. As you might have guessed, that product is cash value life insurance.
The are a few different types to choose from and further down, you’ll see why the Indexed Universal Life is usually your best bet.
Using an Life Insurance for College Funding
Ok so remember how I said that children generally don’t need life insurance on themselves? Here is an exception to that rule.
This works best for people who are currently showing more than $180k of income on their tax returns, but remember we have to plan for almost 20 years out – if tax laws continue to get more progressive, FAFSA could force anyone who makes a dollar more than the median household income to bear the full cost of college.
The FAFSA calculation takes into account your earnings, your assets (including retirement), any 529 plans, income, or retirement funds for your child. It does not take into account the cash value of either a life insurance policy on yourself, or a life insurance policy on your child.
I think you can see where I am going here – I would suggest you use a calculator for your specific situation first, but as you can see, excluding the 529 assets can have a huge effect on your expected family contribution.
Of course, you still want to build those assets, and the way that you are going to do it is through life insurance.
Which type of life insurance plan should I use?
Remember, we are planning ahead here and we want to use that to our advantage. We pretty much have two options – do we want to use the market to help, or do we want to stick with a rock solid slow and steady policy?
If we want to use a product that will give us cash based on how well the market does, we have two choices, an Indexed Universal life policy or a Universal life policy. Indexed universal policies are better than VULs and have a floor to prevent losses in case of a couple of bad years in the market.
If you want to use something more slow and steady that pays dividends every year, a whole life policy is a better choice for you.
I prefer the first option, especially when we have about two decades before we start needing the money to pay out, but using a whole life policy.
We want to make the cost of the insurance as low as possible, so it’s preferable to make your child the insured while you are still the owner. In addition, we can use a couple of tricks to overfund the policy and get more cash compounding tax free than is normally allowed.
Interested in hearing more? Grab a free, no obligation consultation with me!
Other shortcomings of the 529 plan
The government encourages you to contribute to a 529 plan – so much so that the total contributions allowed are close to $400,000 (this is set individually by each State plan, but all of them have a maximum contribution well above the cost of college – which doesn’t include capital gains, dividends and interest)
In addition, contributions to 529 plans are treated as gifts. However, unlike normal gifts, you can contribute up to 5 times the maximum gift amount upfront without needing to file a gift tax.
First the Carrot, Then the Stick
Any time the government offers carrots – Beware! The stick is always nearby.
In this case the government offers you a huge total contribution limit, a way to get 5 times more money in on day one, and tax free accumulation of growth and interest.
What do they want in return?
The big caveat for 529 plans is that they must be used for education expenses. Using them for any other purpose results in all of the gains being taxable and a 10% penalty!
Even worse, depending on the state plan your 529 is under, they may make you recognize that income at your marginal rate!
That means a high earner who is in the 33% or above could be looking at federal taxes of close to 50% (remember, you have to add the 10% penalty) of the gains and interest, plus any state tax that is involved.
Don’t forget about the tax credit recapture either! Depending on your individual situation, you could come close to not getting much more back than you put in!
While everyone intends to use their 529 money for education, there are several reasons why that might not be the case. Planning for your child’s education nearly two decades in the future has several potential pitfalls.
- Your child doesn’t end up attending college
- You or your child need the money for something else
- You overfunded the 529 plan
Your child doesn’t end up attending college
Most Millennials were raised by their boomer parents to think as college as just an extension of high school. Everyone in my age demographic was told to prepare for college pretty much since the sixth grade.
Anyone who was marginally smart enough to go to college was encouraged to take out unlimited funds to attend, and no 18 year old seriously weighted the cost of an English degree vs. it’s expected payout.
At the moment, going to college is still worth it for most, but high schoolers and parents are now more seriously performing a cost benefit analysis – which is a good thing.
Many high wage blue collar jobs are going unfilled at the moment, and with rising wages and growing apprenticeship programs, more young Americans have a chance to get a good paying job without the cost of college.
There is also the other possibility – Despite our best efforts, not every child is going to make it into college. If that’s the case you may or may not still want to assist them.
With the 529 you can either cash it out for them, which costs taxes and penalties, or you can role it to another family member (including yourself) but the only way to get that money out without a penalty courtesy of the government is to spend it on education.
With a life insurance plan, no such restrictions apply. You are free to spend the available cash at your discretion – and the money is still tax free. You are also able to retain ownership of the policy if you so desire, which means that while your kid is the insured (with all the benefits that it confers) you can prevent your kid from being able to access the cash inside of it – you are after all the owner of the policy, and will continue to be until you choose to transfer it.
You or your child need the money for something else
This is probably the most complicated scenario – and also the most common one.
Most Americans suffer from a case of optimism – which is why 74% of Americans have less life insurance than they need, and this optimism extends into their general financial planning as well. We are always planning for what can go right (i.e., My kid is going to go to the best school out there) that we often forget to plan for what can go wrong.
Life insurance is one of those products that isn’t exciting or sexy – there are no shows devoted to it on CNBC – but it’s the only product that can protect your family against the ultimate downside for pennies, which gives you the freedom to plan for the upside.
People who end up in this category of needing to draw money from somewhere besides their bank account tend to be low to middle class earners who would have been poor candidates for saving money through the life insurance policy anyway (Remember, it’s all about avoiding taxes and showing assets to FAFSA), but running out of cash is something that can happen to anyone.
That being said, the 529 becomes a tempting target because the funds are there, and you can always tell yourself that you’re going to put the money right back. Usually, that never happens.
What does happen is you pay the 10% penalty on any funds that are not specifically used for education, so don’t overcommit to a 529 if you don’t have an emergency fund.
You overfunded the 529 plan
Pretty much the opposite problem than the last bullet point, you can easily overfund too much into 529 plan, leaving plenty of cash to be taxed and penalized after your child goes to college.
This is actually pretty common among large, wealthy intergenerational families where the contributions are not coming just from one parent.
If you are lucky enough to be in a position where grandparents and extended family members have the means and will to contribute, it is certainly possible to overfund the 529 plan.
An aggressively positioned portfolio with a stronger than average market can also contribute to overfunding- remember you’ve potentially got two decades for this money to grow –
A great example is my old boss – he was a highly paid financial advisor who had 100% of his kids 529 plan in high growth mutual funds. Back when I was working for him, he already had over $200k in the plan for his 11 year old son.
Having $200k with another 7-8 years to go sounds great, and it is – these are the sort of problems that most people wish they had, but they are still problems.
His 529 account balance could easily reach $300,000 by the time his son is ready for college, and if he is planning on going to the same college as his father (Syracuse) He may spend only about half the balance – and if he’s not going planning on graduate school after, he will owe tens of thousands of dollars to the IRS for the mistake of making too much money.
Like I said at the beginning of this post, 90% of Americans are better off using a state 529 plan to save for their children’s college. If they need insurance on themselves, picking up a cheap term plan is a better option.
For those of you who in the top 10% of income however, a permanent life insurance policy that you can draw tax free cash out of starts to become a better alternative as more of your income is exposed to higher marginal taxes and the FAFSA calculation starts removing any chance at getting Federal Aid.
If this is something that concerns you and you’d like to explore your options with a professional, grab a time on the calendar or email me at [email protected]