The Typical Debate between Whole Life and 529 Plan Proponents
If you search the Internet for a comparison between a 529 plan and Whole Life insurance, you’ll find polarizing viewpoints. Half of the resources love Whole Life as a vehicle to save for college, and provide compelling arguments. And the other half of the resources suggest that Whole Life is too expensive or too confusing, and point to the 529 as the better choice.
So which is it? What is the best way to save for college? In this article we’d like to share an overview of the current climate of college saving, and also provide some advantages and disadvantages of both Whole Life and 529 plans.
But before we get ahead of ourselves, let’s ask the basic question – is saving for college necessary?
Is Saving for College Necessary?
A recent survey of 1000 hiring managers stated that less than 40% of University graduates were prepared for their jobs. This information, along with the staggering increases in college tuitition, have caused many in America to question if college is worth it. In addition, the recent growth of the Gig Economy (one-time contract jobs or “gigs”) suggests that many people are doing something about it. Source
For many the high cost of college, and the increasingly poor ROI (return on investment) turn them away from expensive colleges. Those with the option to go to an Ivy League school, or with a desire for a specialized profession (doctor, engineer, etc.) have a greater reason to pay the high cost. But for the majority of Americans, expensive college degrees are no longer considered the help that they once were.
But when you’re a parent, and you don’t know what your child will eventually want to do, your best option is still to prepare for a variety of options. This is one of the reasons why we actually like Whole Life insurance as a tool for saving, because the cash value can be used for just about anything. We’ll talk more about this later, but it’s gets the ball rolling.
Dispelling One Myth: Whole life is much more Expensive
Before we begin, we wanted to dispel one myth. Or at least address one criticism straight away. The biggest criticism of Whole Life insurance is that it is expensive. This is like a Mercedes-Benz car salesman sitting across the street from the BMW dealership and stating that BMW’s are too pricey.
It’s true that BMW makes some expensive model cars. But it’s also true that they make a model that is less than $30,000 brand new. It’s all about your choice and options.
The same is true of Whole Life insurance. You can choose to buy a policy with a large death benefit and you’ll have a large premium. However, if your goal is to save for college – you should choose a policy that is meant for cash value growth. We recommend a low death benefit (lower cost) and high paid up additions. This translates to low fees, and accelerated cash value growth.
Blanket statements about Whole Life costs are not helpful and may be misleading.
Advantages of Whole Life for College Saving
Whole Life insurance, also known as permanent life insurance, is structured so part of your premium pays for the insurance, and part goes to a separate cash value account. The cash value grows at a steady rate with minimum guarantees every year. The guarantees are typically low, around 3-4%, but again, they’re guaranteed. Keep in mind that mutual companies will pay dividends in addition to the guaranteed rate, so in reality you end up with the guarantee plus another 2-3%.
These policies are funded with after tax dollars and are therefore able to grow tax deferred. You are always able to withdraw your basis (the money you put in) without paying tax, because you already paid it. But this is really just the starting point. Most people choose to use policy loans to borrow against their cash value using a wash loan – or in some cases gaining via arbitrage. In other words, they can use their cash value as collateral for a loan, and the interest they are charged is equal to the amount they are credited – so it’s like getting a 0% rate.
3. Few Contribution Limits
There are limits on how much cash value you can have, but they relate to the amount of insurance you have, and the timing of the contributions. However, with respect to saving for college, the limits for paid-up additions are well in excess of any ivy-league college costs.
Contribution limits typically come up when parents are trying to catch up late in the life of their future college student. Critics of Whole Life will state that in the first few years it’s difficult to save because of all the up-front administrative costs. However, remember that paid-up additions fly in the face of that argument. With paid-up additions you can quickly start saving for college expenses. But also note that the longer you have to save, the more time your cash value has to grow.
4. Hidden to Financial Aid
Life insurance values are not considered when applying for financial aid. So even if you have over $100k in cash value, it won’t even be seen by those considering financial aid.
This is of tremendous value when it comes to applying for aid, because there are so many options available to families looking for financial aid. Pell, FSEOG, and TEACH grants. Merit and Athletic scholarships. Work-study programs. And of course there are military grants and scholarships as well.
5. International College Funding
This may not be something you’ve considered, but for the purpose of the comparison with the 529 it needed to be mentioned. Whole Life cash value can be used to fund college expenses anywhere in the world. There are no limits to what college can be chosen.
Ultimately the money inside a Whole Life cash value policy can be used for whatever you want and whenever you want, with very few restrictions. There are no early withdrawal penalties. There aren’t any distribution guidelines. And you won’t have to worry about qualifying expenses. Essentially it’s all your money and you can do with it as you choose.
Disadvantages of Whole Life for College Saving
1. You must Qualify
A Whole Life insurance policy is insurance on the life of the insured. As such, the insured is required to qualify for life insurance by taking a medical exam (in most cases) or by answering a questionnaire. In addition there is an element of life insurance that is being purchased, so they can be more expensive. But then again you are getting a guaranteed death benefit as well.
For those with significant health risks, the Whole Life college saving plan may be more costly than needed. If you’re in excellent shape and have few health risks, you may find that the costs are well worth it.
2. Additional Cost
As mentioned earlier, the Whole Life college saving plan is a cash value account AND a life insurance policy. The two together make up the Whole Life policy. The cost of the insurance can be more than the cost of a 529 plan depending on your choices. But keep in mind that you are getting life insurance along with your college savings account, an additional benefit.
Advantages of 529 Plan
Both Whole Life and 529 plans are tax-deferred, meaning they are paid for with after tax dollars and grow tax deferred. This means that you don’t get a tax bill each year even though your account is growing and you are “earning” money each year. The money you contribute each year is after tax, and the money that is earned as interest is not considered earned income as long as it stays in the account.
In addition there may be some state income tax benefit to investing in this type of account. Depending on your income tax bracket and your contributions. If you contribute $10,000 in one year and the income tax for the state is 5%, you will save $500 on your taxes that year because of the contribution.
2. Growth Potential
When you choose a 529 plan you are essentially choosing mutual funds. These various funds are all invested in a broad variety of market options. With these options comes the opportunity for good investment gain when the markets are performing well.
Just like any other market investment, when the market is performing well, everyone seems to be happy and the results end up being in line with our expectations. The longer you have to invest and prepare the riskier you can be with your choices. If you don’t have a long time, you’re better off choosing safer investment options like bonds or CDs.
3. Popular / Variety of Options
As with most stock market investment options since the 1980’s, the 529 is very popular. This means that you have a lot of options and can usually find people that are knowledgeable to help. The 529 plan is not something new, having been created by Congress in 1996.
You can choose to invest in State sponsored 529 plans, or you can go with your typical financial company sponsored plan. The main difference between the two is that you will likely have more options and variety with the financial company plans, but you’ll pay more. State sponsored plans typically have fees under 1%. And financial companies can charge anywhere from 1.5% or more on the account.
Disadvantages of 529 Plan
1. Qualified Expenses Only
The reason the IRS allows this plan to be tax deferred is because they expect these funds to be paid to United States education institutions. As a result, they require that all expenses be directed in this manner. This means that there are some things that are not approved to be purchased with 529 plan funds, and it’s up to you to make sure that it’s spent properly.
Rent off campus is allowed, but only up to the individual school room and board allowance. Books are covered, but non-required study guides are not. Food is allowed, but only for limits up to the individual school room and board allowances. Keep your receipts – you’re dealing with the IRS.
2. More Risk
As with any investment that is in the market, there are risks associated with attempting to get the higher gains. For those with a longer investment window, meaning college is farther off, it may not be an issue. But anyone that saw the markets in 2008 can tell you that one bad year can destroy a decade of slow and steady gains.
529 plans offer options, and some of those are labeled “aggressive growth” for a reason – they are risky. As with all plans that offer significant upside gains, you will be required to accept the downside risk.
If you fail to use the funds for qualified educational expenses, you will incur a 10% excise tax penalty AND associated income tax on gains. Let’s say you withdraw $20,000 for the year because you expect the associated college expenses to be that amount. If the expenses only end up being $16,000, you’ll pay a 10% penalty ($400) on the $4,000 that was not used for qualified expenses, and you’ll be charged income tax on it as well. If you’re in a 25% tax bracket, you’ll pay a total of $1400 because you failed to use all the money on qualified expenses.
4. U.S. Colleges Only
Finally, it’s important to note that the IRS is not going to give you money to spend overseas. The 529 plan only considers U.S. Colleges to be qualified institutions of learning. If for some reason your son or daughter chooses to study overseas, the 529 plan will need to be transferred to some other family member.
As you can see there are a variety of things to consider when you are thinking about saving for college. We at InsuranceandEstates.com feel strongly that a properly structured Whole Life policy is the best saving tool for college, small business, real estate investment, or pretty much any other self funded endeavor. However, we realize that each person and family has a unique situation and may find a suitable tool elsewhere. We hope that this article has provided some helpful information on the subject. If we can be of any help, please don’t hesitate to reach out to us.