We all know how expensive a college education has become. To pay for college, families often rely on the combination of student loans and tax-deferred 529 college savings plans.
Needless to say, this approach is far from perfect. No one likes being saddled with student loans. And even though 529s are referred to as “savings” plans, they are simply tax-deferred investment vehicles, and fully subject to market risk.
In the past I’ve written about using life insurance as a way to fund college costs while avoiding student loans and market risk. You can read the background here. But how does using insurance to pay for college work? I’ve sketched out an example that illustrates exactly why it can be such a shrewd arrangement for a family.
The family: September is here, and Tom and Elizabeth Smith are sending their son, Ben, off to college. It will cost a lot, but they are ready: When Ben was seven years old, the family took out a permanent life insurance policy on the child, with the intention of using it to pay for Ben’s college.
The policy: Tom and Elizabeth chose an Indexed Universal Life policy. IULs allow the policyholder to capture market appreciation without the downside risk. Their policy has a “cap” that allows them to participate in 100% of first 14% of the appreciation of an underlying index. The policy also has a guaranteed zero-percent “floor” that prevents them from losing money when the market has a down year.
Although the market rose and fell quite a bit in the years after the family took out the policy, the cap and floor features helped create a respectable return of 7%–and save Tom and Elizabeth a lot of worry. After 11 years, the policy’s account balance has grown to $150,000.
The process: To finance Ben’s college education, Tom and Elizabeth will borrow from their insurance company against the policy’s cash value, with the expectation that Ben will, over time, give them the funds to repay the loan.
Ben’s college costs will be approximately $80,000 for four years. His parents can lend him $20,000 per year. (They could also use student loans as part of the equation if they chose to, because the cash value of an IUL is not considered an asset for financial aid purposes.)
Because of their policy’s careful design, Tom and Elizabeth are not obligated to make loan payments while their son is in school. Nonetheless, funds in the IUL will continue to grow during Ben’s college years because the assets in the policy never leave the policy; they are merely collateral for the insurance company’s loan.
After college: Because of a recession, Ben has trouble finding work in his field of interest. His friends must take any job they can find to start repaying their student loans. But Ben is not under the same pressure, because his parents can repay their loan to the insurance company on their own timetable. The family has agreed that Ben will begin repaying the loan when he is situated in a well-paying job.
After repayment: Once Ben repays his debt to his parents, Tom and Elizabeth must decide what to do with the policy, which has served its original purpose. They have two options. They can transfer ownership of the policy to Ben, who will be able to use it for lifetime borrowing transactions and to fund his retirement. Or they can use the funds for their own retirement income.
By using a custom-designed permanent insurance policy to fund college, Tom, Elizabeth and Ben have avoided market risk and student loans—all while keeping (and growing) their wealth within the family. This is a family that understands the power of financial independence! If you’d like to discuss college funding, don’t hesitate to contact us.
