Life insurance companies are marketing cash-value life insurance policies, including whole life insurance, indexed universal life insurance and variable universal life insurance, as options for saving for college. These life insurance policies couple a life insurance policy with tax-deferred investments. The earnings on the investments can be applied to future premiums, yielding “permanent” life insurance. The insurers claim that cash-value life insurance policies may be used to shelter assets on the Free Application for Federal Student Aid (FAFSA) and that the family can tap into the cash value to pay for college.
However, families should avoid cash-value life insurance policies because of numerous problems with the policies. These life insurance policies benefit the insurer and the salesperson more than they benefit the family.
The cash value of a life insurance policy is not reported as an asset on the Free Application for Federal Student Aid (FAFSA). However, distributions from a cash-value life insurance policy must be reported as taxable income or untaxed income to the beneficiary on the subsequent year’s FAFSA.
One may borrow from the cash value of the life insurance policy. But, the interest paid on the loan merely replaces the earnings that would have been received if the money had remained invested. The interest is not tax-deductible, unlike the interest on federal and private student loans. If the family does not spend the loan proceeds before filing the FAFSA, the proceeds must be reported as an asset on the FAFSA. If the loan is not repaid, it may reduce the cash value and death benefit of the policy. Interest capitalization can reduce or eliminate the cash value of the insurance policy.
Cash-value life insurance has high fees, high commissions and a low return on investment. There are also high surrender charges for early withdrawals, limiting the appropriateness as a college savings vehicle for families whose children are four years old or older.
The premiums on a cash-value life insurance policy may be an order of magnitude higher than the premiums on a similar term life insurance policy. The premiums on cash-value life insurance are not deductible on income tax returns, unlike contributions to retirement plans and college savings plans.
Whole life insurance plans that insure the child – who typically has a very low risk of death – generally have returns on investment of just 2% or 3%. That may be higher than the interest rate on a short-term bank certificate of deposit, but not better than other investment options.
Term life insurance provides pure insurance against the death of the insured, without the complexity and risks of cash-value life insurance. There are two scenarios in which a family should consider term life insurance:
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