As the costs of higher education continue to rise, many parents worry about how they will pay for their kids’ educations without requiring them to borrow staggering amounts in student loans. In order to save for future tuition expenses, some families use a tax-advantaged tool called a 529 plan. While 529 plans offer a variety of benefits, another investment vehicle may offer a more flexible solution: life insurance retirement plans (LIRPs).
If you are considering the options available for saving for your children’s college educations, here is an overview of 529 plans and LIRPs:
What is a 529 plan?
Designed with the specific goal of encouraging saving for future education expenses, 529 plans—also known as qualified tuition plans—are sponsored by states and some educational institutions. Contributions to a 529 plan enjoy tax-deferred growth, and withdrawals are tax free as long as they are used for qualified education-related expenses as defined by the IRS. In addition, most states offer a tax deduction or credit for contributions made to a 529 plan. You may use a 529 plan regardless of your income level. While contribution limits vary from state to state, you can generally fund the plan with more than enough money than will be needed for your children’s education.
There are two different types of 529 plans:
- Education savings plans. Education savings plans are individual investment accounts that allow you to choose from a variety of portfolio options, including mutual funds and exchange-traded funds (ETFs). Withdrawals may generally be used to pay for qualified education-related expenses—such as tuition, room and board, and mandatory fees—at any college or university, including some located outside of the U.S. This type of 529 plan may also be used to pay up to $10,000 per year, per beneficiary for tuition at a public or private elementary or high school. Education savings plans are sponsored by state governments, and a few have residency requirements for the account holder and/or the beneficiary.
- Prepaid tuition plans. Less commonly used than education savings plans, prepaid tuition plans allow you to purchase credits at participating colleges or universities (which are usually in-state and public) at current prices, to be used for future tuition and mandatory fees. These credits generally may not be used for room and board or for elementary and secondary schools.
In addition to tax-deferred growth, tax-free withdrawals for qualified expenses, and generous contribution limits, a significant advantage of 529 plans is that they can be used to transfer wealth between generations while avoiding the federal gift tax. Generally, gifts of more than $15,000 per year to any individual are subject to the gift tax—but you’re allowed to make a one-time, lump-sum gift to a 529 plan of up to $75,000 (or $150,000 for married couples), with no tax consequences as long as you don’t contribute anything more for the next five years.
Despite the benefits of 529 plans, a major disadvantage is that they are considered assets when applying for financial aid. Therefore, the value of a 529 plan may diminish the amount of aid for which the student qualifies. Additionally, 529 plans are more restrictive since their funds can only be used to pay for qualified education expenses—so if your child opts not to attend college (including trade or vocational school), withdrawals from the account may be subject to income taxation and a ten percent penalty on the earnings.
What is a life insurance retirement plan (LIRP)?
When considering options for saving for higher education, life insurance retirement plans (LIRPs) offer an underutilized alternative to 529 plans. LIRPs are long-term life insurance policies that are funded beyond standard premium payments, with the goal of encouraging growth in the policy’s cash value rather than merely providing death benefits. The cash value of the policy enjoys tax-free growth, and tax-free loans may be taken off of the policy’s value.
With no income limit and no limitations on annual contributions, LIRPs are most commonly used by individuals in high tax brackets who have maxed out traditional retirement accounts and are seeking another option for tax-free retirement income. However, the cash value of the policy can also be accessed tax free to pay for education expenses. As compared to 529 plans, a major advantage of LIRPs is that they are not considered assets for financial aid purposes—so your kids will qualify for the maximum aid available to them, without having to take into account funds that you are devoting to their education through an LIRP.
Another advantage is that LIRPs offer greater flexibility than 529 plans: since the cash value of the policy can be used tax free for expenses other than education, your kids can still benefit from them if they choose not to attend college. For example, the funds could be used to help them purchase a home or start a business. Downsides of LIRPs, however, may include high upfront fees and variation among the success of plans based on how they are designed.
Both 529 plans and LIRPs offer attractive ways to save for your children’s higher educations while enjoying significant tax benefits. For assistance with choosing the right option for your family, contact our team of experts today!
-Stephanie Vance, J.D.
We are Arbor Wealth Management, a Phoenix-based firm that offers comprehensive financial planning services. We’re partners in your financial future. Like a conductor coordinating a beautiful symphony, we’re intimately involved in your financial future. We take the time to know how each instrument in your personal orchestra is performing, keeping all aspects of your plan in tune. We accomplish this by making sure your finances remain pliable, whether you are in an accumulation or distribution stage in life.