Saving for college with... life insurance?



Posted on July 9th, 2021

We've discussed using many different tools for college savings, from UGMA and UTMA accounts to IRAs. You've asked, and we're here to give you some answers about using an Indexed universal life (IUL) account for college savings. We know college savings seems like a daunting process that you want to hack, but spoiler alert, a 529 plan is the hack to make it as easy as possible.
While IULs have been a popular topic lately, keep in mind that most of the people you see promoting them are making a pretty penny if you sign up for a plan, and Forbes, the Executive Director for the Center of Economic Justice, and more have voiced serious concerns about these plans. Several life insurance companies have also been the subject of class-action lawsuits regarding their handling of indexed universal life insurance plans, so be sure to look into a company before purchasing a plan. We decided to give these plans the benefit of the doubt and look into their pros and cons to help you make the right decision for your family.

Part of our research involved sending our 22-year-old intern into the trenches to find out more. In a discussion with an insurance broker, they told her she was a great candidate for a $2,000 a year plan despite having no dependents and being (hopefully) far from dying, retirement, or paying for a child's college. They wouldn't disclose any fees or clear financial information when she asked, and they might've invited her to join a cult. (We kid about the cult thing, but the whole process felt super shady and opaque.)

We've broken down what we learned below.

What is Indexed Universal Life Insurance?

Life insurance is purchased to provide beneficiaries with a large sum of money upon the insured's death. There are various types of life insurance, but the reason this insurance was created was to provide payments for families in the case the breadwinner dies.

Indexed universal life insurance grows differently than typical life insurance. Your money is tied to the performance of a market index. Indexes follow the performance of a group of stocks. There are broad indexes like the S\&P 500, which measures the performance of the entire stock market, or there are more specific indexes that track specific factors like company size, industry, and more. IULs grow with an index instead of at a fixed interest rate. Your money isn't actually invested in the index, and you do not need to take action to invest like other investment accounts. The plan is tied to the success of an index, and the insurance company pays your returns based on how that index performs.

Like other types of insurance, you pay premiums every month or year. The money from the premium pays any fees and costs associated with running your account, and the rest of the money goes into the cash value of your account. You earn interest based on whatever index your plan is tied to on the cash value of your account.

The main benefit compared to other types of investment accounts is that you don't lose money when the market goes down. If the market goes down you will not earn negative returns, but you won't earn any interest for that time period. On the flip side, most IUL plans have a cap on the percentage you can earn in returns each year. These caps vary from plan to plan, but during good years they prevent you from earning as much as you would have invested directly in the market or in a 529 plan.

TL;DR I want to save for college the smart way

Pros of Indexed universal life insurance

Unlimited contributions

IULs have no contribution limits. You can withdraw funds from an IUL at any time, so if you are planning to use an IUL as retirement or college savings fund, you can contribute as much as you need to the account.

Tax-free growth and distributions

IUL insurance policies grow tax-free, and you do not pay capital gains on the plan's increase in value over time. You are also able to take loans from your IUL without paying taxes or penalties for early withdrawals.

Flexibility to use whenever and for whatever reason

You can use the funds at any time for any reason without paying a penalty or taxes. There are no minimum age requirements.

Death benefit

The beneficiaries of your plan receive a tax-free death benefit. There are no income or death taxes on the benefits your beneficiaries receive.

Low price for insurance premiums

Relative to other types of life insurance, IUL premiums are low because the policyholder takes most of the risk. While the premiums are low, you still have to make consistent payments to the account. Your premium covers the cost of running your plan, so any fees are paid and the amount of money left over goes into the cash value of your plan. The cash value of the plan is where you earn your returns. You can adjust your premiums based on your goals. So, if you want to contribute a lot of money early on and then slow contributions later on, you are able to do this as well with most plans. Your premiums act as your contributions to the account.

No penalties on withdrawals

Depending on your policy and how much cash in the policy you are able to withdraw money from your account for any purpose. There are no penalties or taxes if you have the funds available to borrow, and you don't have to pay yourself back. If you withdraw income you earned on your contributions, you will owe taxes. Keep in mind this will affect the benefits available to beneficiaries if you pass.

Does not affect your FAFSA

Life insurance is not reported on your FAFSA as an asset. This means any assets held in your IUL will not affect your expected family contribution.

Cons of Indexed universal life insurance

Earning limits

Most plans have a limit to how much you can earn within the plan. Index caps set a limit to the rate of return you can earn, which means an index can perform really well but you're only earning a portion of those returns on your IUL funds. The plans protect you in a down market, but if the market has a good year you will earn less money than if you invested directly in the market. IULs serve their purpose as a type of life insurance. If you are planning on using funds from an IUL for another purpose besides life insurance, investing directly in index funds or retirement accounts with no earning limits is a better option.

Index funds also have participation rates. These vary from plan to plan, but a participation rate affects how much of the returns you earn. For example, if your participation rate is 70% and the index earns 10% that year, you would earn 7% on the cash value of your plan.

Taxable income

While IULs grow tax-free, if you close the plan before it matures, or the policy lapses because you stop paying the premiums, the money you have withdrawn from the plan becomes taxable. If you plan on withdrawing funds to pay for college or retirement before the plan matures, make sure you realize that you're committing to paying the premiums on this account for the long haul.

Based on an equity index

If the value of the index your plan is tracking goes down, there is no interest on the cash value of the plan. This means your policy doesn't grow if the value of the index your plan is tied to goes down.

Flexible premiums can hurt you

Although flexible premiums might seem like a perk, these are really non-guaranteed premiums. You can skip payments, but the insurance company can raise your premiums and require more money to cover costs that grow over time. As a policy-holder ages, they become more expensive to insure. So over time, more of your premium dollars go towards costs and fees and less go towards the cash value of your IUL. Eventually, these fees can drain the value of the policy, especially in years where the market is down and companies are losing money. The policy can raise its premiums to cover rising costs. You can choose to pay the higher premiums or give up the policy. But remember if you give up the policy you will likely owe taxes on the earnings of the plan.

Insurers are not obligated to protect you

Many insurers and insurance agents are not selling you IULs with your best interest in mind. They are not obligated to protect you and often sell extremely complicated plans without disclosing some of the potential risks. They often also provide projections of a policy that make it seem like it will be costless in the future, but these projections are not guaranteed and can cause customers to pay a lot more than they were expecting for life insurance. Think of IUL salespeople like car salespeople- they are trying to get the biggest sale out of you, so you need to do your research first.

Long-term commitment

Most life insurance plans are 40 years or more- they're meant to last for your lifetime. This can be great with typical life insurance with steady premiums because the family of the insured will receive the benefits for a long time. For IULs this can be a bad thing. Policies often have significantly more expensive premiums over time and can eat away at the cash value of the plan. Remember that you have to hold on to these plans or face tax implications, so be sure that you are committed to having this plan for the long haul and potentially paying more as premiums increase over time.

IULs are not regulated by the SEC

Unlike stocks and options, IULs are not regulated by the Securities and Exchange Commission (SEC). This commission is to ensure that companies and brokers are honest when reporting financial information. Stockbrokers need to undergo rigorous training to sell products tied to indexes, whereas insurance salespeople do not have the same standards. The only requirement for insurance brokers is to be licensed by the state.

Complicated nature of plans

IULs can be very complicated depending on your plan. Each plan has different premiums, rules for withdrawals, maturity dates, etc. so be sure to read the fine print when setting up an account. Cap rates and earning limits are commonly included in plans, so make sure you are shopping around for a plan that isn't meant to limit the growth of your money and pass on earnings to the insurance company.

Another complication is the fee structure. IUL policies can have very high fees that are not always clear upfront. Common costs include premium expense charges, administrative expenses, riders, fees and commissions, and a surrender charge. Most plans have four types of fees: the premium load, the monthly charge, the expense charge, and the mortality charge. Make sure to understand these fees upfront. Keep in mind that these fees aren't factored in when a company tells you your returns, so make sure to do your own research.

Also, be sure you know which index your money is tied to. Some IULs are tied to the S\&P 500 and other well-known indexes, but others are tied to less established indexes that could be higher-risk.

So what?

IULs can protect your family in the case of untimely death and are useful in certain situations. But when it comes to saving for college, the low fees and unlimited growth of a 529 plan make these plans a better option. Although IULs promise to protect you against losses in the market, the limit on growth can end up hurting you. Chief Investment Officer of Ellevest, Sylvia Kwan explains "If you had invested in the stock market from 1999 to 2018 and not touched it, your money would have tripled. But if you had traded in and out and had missed out on just the 10 best stock market days over that period - just 10 days - your returns would have only been half of that."

Investing is scary, but just because IULs promise you won't lose money when the market goes down doesn't mean these plans are the best investment option. There are major downsides to these plans including growing premiums and capped returns. Plus the complicated nature of these plans means you should strongly consider using a financial advisor to help you set up a plan and make sure it's the right fit for you.

There is no hack to college savings. A 529 plan was designed to do the job best. It is simple, has low fees, and offers better returns than an IUL. If you are planning on using an IUL for college savings, remember that you'll have to continue paying the premiums long after your child goes to college, and that could cost you. A 529 plan also offers you the flexibility to contribute when you can and put your money elsewhere when you can't.

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