REFINANCE: Life Insurance Fails as a College Savings Plan

If you’re worried about saving enough money to send your kids to college, you might be tempted by a sales pitch for a cash value life insurance policy.

Sometimes these policies are touted as a great way to save for college tuition. Besides paying a death benefit when you die, these policies, also known as permanent life insurance, feature a cash value account that grows tax-deferred.

Assuming you buy the policy when your kids are very young, by the time they head to college, you can withdraw the money or borrow against the account to help pay for college. And the kicker: Life insurance policies don’t count as assets when colleges analyze your need for financial aid.

But college finance experts warn parents not to be taken in by the pitches. Cash value life insurance policies are expensive, complicated and unnecessary for most families.

“I have yet to see any of these life insurance plans that were in a parent’s best interests,” says Mark Kantrowitz, an expert on college financial aid and author of “Twisdoms about Paying for College.”

“The only people arguing for these are the ones who are going to make commissions from selling the policies,” he says.

The pitch

About 10% of financial advisors recommend cash value insurance policies for some clients to save for college expenses, according to a 2015 report by Strategic Insight, a research group in New York focused on the mutual fund industry. That’s down substantially from three years ago, when 29% of them said they were doing so.

While the sales tactic has been around for decades, college financial aid experts say the use and promotion of it comes in waves.

Financial advisors who make commissions off product sales will sometimes rent out a conference room at a restaurant or hotel and invite parents to a free dinner to learn about saving for college, Kantrowitz says.

Afterward they meet with families one on one, often urging parents to liquidate CDs and savings accounts to buy a cash value life insurance policy so they can shelter those assets from college need-based financial aid calculations. Some salespeople go even further and encourage parents to tap home equity and retirement accounts and pour money into the policies.

That’s a terrible idea on its own but especially when you consider that retirement assets aren’t included in need-based financial aid calculations, either. Nor is home equity, at least for universities that rely on the Free Application for Federal Student Aid, or FAFSA. Some colleges require an additional form — the CSS/Financial Aid Profile — that considers home equity but limits the impact on its calculation.

Kantrowitz says some parents are even borrowing money to invest in cash value life insurance for college purposes.

The trouble with life insurance as an investment

One drawback to cash value policies is that they contain hidden costs, such as big surrender fees if you cash out of the policy in the first years, says Sean Moore, a certified financial planner and president of SMART College Funding in Boca Raton, Florida. Loans against the policy aren’t free, either, but must be paid pack with interest. If you don’t repay the loan, the death benefit is reduced. Agents typically get commissions equal to 80% to 100% of the first year’s premium, which means less money goes into your cash value account.

Critics also say life insurance product illustrations, which show how the cash value account could perform, are often overly optimistic. The question to ask, Moore says, is “What if it doesn’t perform as expected?”

Finally, the policies are complicated. They vary widely, are hard to compare and have a lot of moving parts because they combine insurance coverage with an investment component. “I don’t think people who buy them understand them,” Moore says.

Better options for saving

Before considering a permanent life insurance product as a college-savings vehicle, parents should fully fund a 529 plan, says Paul Curley, Strategic Insight’s director of college saving research. A 529 plan is a tax-advantaged college savings account sponsored by a state or state agency.

That doesn’t mean ignoring life insurance all together. In fact, having life insurance while your kids are growing up and in college can be an important financial safety net in case a parent dies. Term life insurance is an easy way to cover those years.

Term life provides coverage for a certain period, such as 10, 20 or 30 years. You choose the term length and buy the amount of coverage to protect your financial dependents.

The policy pays a death benefit to the beneficiary if the insured person dies within the term. Because the policy is temporary and has no cash value, the coverage is cheap.

Finally, if an amazing sales pitch for permanent life insurance still piques your interest, talk to a “fee only” financial advisor who does not make commissions on sales.

“Get advice from someone who doesn’t have a vested interest in you buying one of those products,” Kantrowitz says.

To find the right coverage amount and compare prices for term life insurance, use NerdWallet’s life insurance comparison tool.

Barbara Marquand is a staff writer at NerdWallet, a personal finance website. Email: bmarquand@nerdwallet.com. Twitter: @barbaramarquand. This article also appears on Forbes.

Image via iStock.