College Funding Part II

So last time we covered that cash value life insurance is a great vehicle for your college funding plans because it yields favorably and is extremely reliable.  On top of that, it's also rarely included in financial aid eligibility calculations and can be used for anything and have a tax free distribution, not just so called “qualified” educational expenses.

Today, we're going to dive a little deeper and hammer on a topic we've brought up before.  The fact that  you can use cash value life insurance to pull double duty and help you accomplish more than one financial goal, and do it better than individuals plans.

Let's Start with the “Traditional” Approach

We know the traditional approach is a 529 plan.  529 plans, if they work according to plan, are designed like most financial savings plan.  You save a certain amount for a period of time, and then open it up and spend all of the money.  That's circa 20 years of sacrifice to send your child off to college, and having nothing more than the pride and joy of seeing her graduate and find a rewarding career. So you take the traditional approach and once college begins, you start ripping into the 529 (that's what it's for after all).  So let's say best case scenario you've saved enough to pay the entire cost of attendance.  At my alma mater one year is figured at $53,790 or $215,160 after 4 years–assuming, or course, that your darling child graduates in 4 years (I did with three majors, but knew plenty of people with just one who took a little bit longer).  $215,160 is a lot of money after all the clothes, computers, cars, sports equipment, braces, and whatever else you spent your money on for the first 18 years.  But that's the plan at the moment under the 529 approach.

So what's your Magic?

I get asked this question from time to time, and I understand.  What with all the hustlers out there who know that selling insurance makes them money, and that's about the depth of their knowledge on the industry.  There's no magic here, just a switch in procedure, and I'll explain.

So what happens when we change our approach and instead focus on a plan that doesn't mean just because we use the money, we lost it.  Remember that bit I did the other week about lost opportunity by pissing away your wealth building opportunity?

So let's take an example where we save $10,000/year starting at age 30 to send our child to college.  I'm going to use a Universal Life policy for my example here.  Why?  Because I get criticized for being anti-UL and I'm going to prove this is just as do-able with a UL contract.  That and UL has a few features that make it much less labor intense on the design side to get the illustration  where I want in less time.  On top of this, I'm going to use an indexed UL contract (queue dramatic music).

After 18 years I've got more than enough money to send my kid to my alma-mater, and to follow along I'll remove $40k/year.  Why $40k?  Because I'm going to take a break from regular contributions for 4 years and have an additional $10k to put towards cost of attendance (I'm also rounding down to $50k because it's quicker and easier, the magnitude of the numbers doesn't change).   After the 4 years are over, I'm going to get serious and start really saving, by placing $25k/year into the policy.  Once I hit age 65 my UL policy has a little over $750,000 in it for me to use at my pleasure for retirement purposes.  Oh and for the UL pros, I'm sure you're begging to know my hypothetical interest rate, I'm using 6%, not the default 8% in the illustration interface.

So how does this compare to the 529 approach?  Well, lets say that we save the same 10 grand in a 529, after 18 years we have around $309,000 assuming a 6% rate of return.  We spend the same $40k/year which brings our $309k down to $149,000.  Now, the remaining money will need to be removed from the 529 in order to use if for future savings.  Our taxable basis in the plan is $180,000, of which we've removed $96,000, so we have $84,000 remaining.  How do we get that?  529 distributions are neither LIFO or FIFO, they instead us a proportional mix of basis and gain.  In our case we have $180,000 of basis and $129,000 of gain for a total of $309,000.  It's almost a 60/40 split; we'll round up to put things in favor of the 529 plan.

The $65,000 gain will need to come out and be realized as ordinary income, likely pushing us up to a higher tax bracket.  So, we'll have about $$129,500 total assuming a 30% tax hit, which is reasonable considering our current income and possibility for state income taxes.  Additionally I should note there might be a state income back tax liability if a state income tax deduction was used as part of the contributions, we will keep this variable external to our model for simplicity's sake.  We'll start the same savings plan from before, $25k/year.  However, we have a bit of a problem.  Unless we're in a rare circumstance, we can only contribute a maximum of c. $15k/year to the most common employer sponsored retirement vehicle, the 401k.  We aren't yet old enough to make the catch contribution, so with a traditional IRA, we're $5k shy of the the amount we really want to save.  This means we'll have to find another vehicle that will allow us to save money on a tax deferred basis to accept the other $5k.  On top of this, the $129,500 can't roll into an IRA, it'll have to be placed somewhere.  A traditional brokerage account is subject to taxes whenever a gain or dividend is realized, making it less than favorable.  So, perhaps annuities are in order (that would make perfect sense, and be a recommendation from a lot of financial advisers I suspect).

After 13 years we'll have the following balances in each account assuming a 6% rate of return:

  • $370,000 in the annuity that received the 529 money
  • 283,000 in the 401k
  • 94,000 in the IRA

All together that's $747,000, which is $3000 less than the projected value in the UL policy.  And that's not too bad a result, a little weak on the UL's side, but we do have to pay actual insurance fees for the death benefit and I'm not using a UL policy for this example that comes with the most generous loan provisions out there.  But wait there's more to consider.  The taxable basis of the annuity is now is $194,500 so taxable gain is $175,500 and since the 401k and IRA were both tax deductible, they have no tax basis making 100% of the funds there fully taxable as ordinary income.  Meaning the actual value is much less.  Let's also not forget the over 1 million dollars we have in non-taxable death benefit we get to keep by virtue of having the UL policy and the over $400,000 non-taxable death benefit we had from the outset which would have paid for college if we'd died along the way–the 529 has no such provision.  Let us also not forget the significantly more stable nature of the UL policy vs. traditional investments.  If the market rallies, the UL policy will increase its overall yielding interest rate (it's indexed so it's tied to a major stock index, the S&P 500).  If the market crashes, the UL cash value simply won't go up very much (if at all).  If the market then recovers the following year, the increase in the UL policy will benefit from this percent change in the index and credit much more interest, whereas those in the market, will merely be making up for lost ground.  We could even lend out a little money form the UL policy in the event of a market crash and actually buy equities or equity rich mutual funds and take advantage of the cheapness of stock prices and make even more money when a recovery occurred (oh my, this almost seems like cheating).

No Magic, Just a Better Idea

Life I said before, this isn't magic, it's simply a way of building a better plan of attack.  Everything is obvious once you already know the answer, the trick is in knowing the answer.  You will never know what direction the market is going in, so you can't waste time worrying about that.  Instead, the best advice I, or anyone, can give you is this: worry about the what you can control.  What you can control is the amount you save, and the degree of risk to which you expose yourself.  Life insurance can recapture some of the lost wealth you'd realize if you didn't spend the money through a policy loan, and its tax favorable provisions and much higher contributions limits (generally speaking in most circumstances) make it a much stronger plan of attack when it comes to planning out the future.


4 Responses to “College Funding Part II”

  1. Jim Tobin says:

    Brendon, why did you use UL as your example rather than par WL?

    • Brandon Roberts says:

      Hi Jim,

      Not a ton a of reason, but the two primary drivers were:

      1. I sometimes get called a WL hack so I wanted to mix it up

      2. I was wrote that blog post on a Mac where the only illustration system I had immediately available to me was Winflex, so I rolled with an IUL in there.

      The idea works just as well with WL if one wants.

      Thanks for stopping by.

  2. Justin Bilyj says:

    I agree with Tobin, any chance you could make a part III to this series using a parWL?

    • Brandon Roberts says:

      Thanks for the feedback. There are a lot of other items on the list, but we’ll consider putting this on the list.

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