College Planning: It S Not Just About 529 Plans

College Planning: It’s Not Just About 529 Plans

Scan the published landscape and you will find countless articles and mutual fund company brochure on how to plan for college. A Google search of “how to save for college” resulted in 1,290,000,000 results. The first 10 had as either the prime or suggested option the use of a 529 plan. It wasn’t until page 2 of the Google search did I locate a list titled ‘the complete list of college savings vehicles.’ This list consisted of 13 items, of which 529 plans was first.

I’m not saying that 529s are not a valid method to fund a college education, however, when you look at the other options and what it can do for you, the reasons for choosing a 529 come into question. Congress created 529 plans in 1996 as part of the Small Business Job Protection Act.

Before I talk about the options, let’s make sure we have a grasp of what a 529 does and does not do.

On the pro side, a 529:

-Permits funds to grow tax deferred for your child’s education

-If it is your residence state, you may get contribution deductions from income tax

-It can be used in any state

-You can transfer the value to another recipient

On the con (negative) side:

-It is not protected from loss (much like your 401k or IRA)

-It does not help in showing a need for financial add (it actually raises what you can afford)

-You cannot take loans from it

-If you have no other child that needs it, unless you pass on to someone outside your immediate family, you get taxed on the gain

Here’s the reality of a 529. If you son or daughter is headed for a public institution, both parents and student will need to complete a FAFSA (Free Application for Federal Student Aid). This documents income and assets for student and parents. From this form, the Department of Education has set up a calculation for EFC (Expected Family Contribution) which takes a percentage of assets and income from both the student and parents. This is used by all public institutions. Take note, that student assets and income have a higher percentage used for education needs.

What does a 529 do for you to save for college? Let’s assume, you will save for 100% of Johnny’s college costs (public institution), tuition will increase 5% a year and that your investments will earn a hypothetical 6% each and every year. If you start when Johnny is born, you need to save $385 each month (the goal is to save $134,000). If you wait until he is 5, the amount will bump up to $465 a month. If you defer even more, say when Johnny is in middle school, you need to contribute $780 monthly. Johnny’s smart and you know you want him to go to private school – bump up the amount starting when he’s born to $1100 a month.[1]

How many of you are ready to start shelling out $400 a month, do it for 18 years and still not be sure you will have enough money for Johnny to complete his undergraduate degree? An interesting note, less than 38% of first time full-time undergraduate degree seekers earned their degree in 4 years, just over half, 55% earned their degree in 5 years and 87% did it in 6 years[2]

If you have 2 kids, you need $800 a month to build for both their education needs. Are you prepared to devote that much monthly for 18 years? Most likely the answer is no, at least not for that sole purpose. All of us have competing needs for our funds – living expenses (housing, food, clothing), entertainment (we’re not hermits), vacation (we do want to enjoy life), personal development (adult and child sports, extracurricular, hobbies, etc.).

How do we tackle the competing needs in an effective manner? One way, is to put funds into a mechanism that can:

- fulfill more than one need,

- provides for flexible contributions (even catch up when times are good)

- permits withdrawals when essential (emergency funds)

Let’s go a little further. We want this alternative to also provide the following:

-Ensure funding in the event you are depart this earth early (in plain English, death)

-Never goes down in value

-Is not counted as an asset for FAFSA purposes

-Has no penalty if you take loans on the value

-Is tax free (subject to conditions being met and maintained)

-Can be used for needs at your discretion

-Can provide for retirement needs

Wow, that’s a pretty tall order. I’ll venture you’re thinking, all right what’s the catch? We’ve all heard the saying ‘if it’s too good to be true, it probably is.’ There is ‘no catch’, it is true and has been around for many years. As a matter of fact, the IRS found that this solution is so good that the IRS put a limit on how much someone can put into this mechanism.

To do a comparison, let’s assume you are a 35 year old healthy non-smoking male and wife is 35 years old as well that wants to provide for college. You have one child and plan to fully fund their education. Earlier we said we needed $385 each month from when the child is born to their 18th birthday. That does the college part (assuming you will get 6% each and every year in gains. Now, being a responsible parent and spouse, you know that some mornings going in to work you witness some fool running a red light and you think to yourself, had I pulled out I could have been T-boned with severe or even tragic outcomes. So you decide you need life insurance. So with your insurance agent you determine that you need $700,000 of coverage. Now the cheapest route is a term policy. Since you might have a second child you look into a 30 year policy. That will be a premium of $50 a month.

You give this some thought and consider insuring you for as long as you live. One option is to keep the term policy beyond 30 years (a 30 year term policy means that the premium remains constant for 30 years). You could this, but the monthly premium jumps to $1876.00 – this is not a typing error.

Ok, not that route, so I’ll just get a new policy in 30 years, you could. Here’s a question “will you be insurable?” Let’s say you are insurable, at age 65, no longer in the best of health, you’re now average health. That same $700,000 will now run you $1085 a month.

What else can you do? You could buy a policy that will cover you for as long as you live andlets you make targeted payments (monthly payment within a specified range). You have the ability to put more or less in depending on your current situation. This new option runs $435 a month. That’s the same we’ve talked about for college and protection with a 529 and term life policy.

Compare that to what you need for college and protection - $385 and $50 = $435. In comparison to the cheapest route (for now) it will require $0more a month. Sounds expensive? Not really, assume you live to age 85, not a day longer.

OPTION A – Term

If you bought the 30 year and then 20 year term, you’d have paid over the life of those policies:

-30 year term = $50x12x30 plus $1085x12x20 = $278,400 with $700,000 benefit

-If you live one day longer than that 20 year policy, your spouse get $0.00

-College is paid for, hopefully with the results of your investments.

OPTION B – Proposed Solution

If you went with the idea your agent had at $435 a month, over the same time frame, you’d have paid = $435x12x30 = $156,600 (you stopped premiums at age 66) with $169,458(cash) benefit and college of $152,000. If you don’t use the policy to pay for college, the benefit is $1,695,513.[3]

You go cheap now, pay until you die and receive a simple return of 2.5 times your premium (assuming you don’t live past age 85). Or, if you were to hold option B, the net premiums paid would be $4600.

Of course, the plan is NOT for you to just pay the premiums. This option will create sufficient cash value such that you can take loans to pay for Johnny’s college education. Besides the education here are some other benefits:

-The cash value of the policy is NOT counted as an asset for FAFSA, thereby increasing your potential for some form of financial assistance

-Should the cash value not be needed for Johnny’s education, you have cash value for other uses, even tax free income for retirement

-The cash value of the policy could fund you premiums, reducing your out of pocket expenses.

At this point you’re saying, ‘how can this be, what is the program that makes this happen?’ It’s an insurance product called an indexed universal life insurance (IUL introduced in 1997)policy. Had I told you this upfront, many people would have dismissed the idea without even having all the facts. I admit, life insurance isn’t glitzy, but when you look at what it does for you, it really becomes enticing. Earlier I commented that the IRS has limited how good this can be. In 1988 congress passed TAMRA, effectively creating limits to how much someone can put into a life policy from a funding perspective in relation to the policy benefits (when a policy is considered an investment – it’s called a MEC (Modified Endowment Contract). Discussion of the way this is controlled is beyond the scope of this article. What is necessary to know is that for the example provided earlier, the annual premium could be as high as $12,921 annually and still be within the IRS guidelines. This is not something the policyholder needs to manage on their own, the insurance company provides guidance in this area. So, as often happens, something good for the public, the government limits, much like ROTH IRAs.

As long as the policy does not become a MEC, the policy owner can use it for a variety of purposes expressed earlier. So how does this work? Let’s not be concerned with how the insurance company manages the program, but how your premiums are processed and how the cash value of the policy grows.

The insurance company deducts fees and expenses from your premium, the net amount is what builds cash value. Let’s assume you make monthly premium payments, each payment represents a bucket of funds that will be monitored against an index (most often the S&P 500). The company looks at the index value on date of premium deposit and compares it to a future date (usually one year). The change in index will determine the growth of the value of that bucket. Most companies will have a ‘floor’ and a ‘ceiling’ of what the growth can range between. Typically, the floor is zero – meaning that your investment funds will NEVER go down (nice). The ceiling could be around 12% (depending on the company).

To illustrate, let’s assume your monthly premium results in $100 to be investment funds (this is how earlier illustration works but not actual numbers). Over the next year, the S&P grows 10%, now there is $110 in the bucket (which can never to go down), add to that your premium for that month and you now have $210 in the bucket. The next year the S&P goes down 15% - your $210 is intact. Adding the monthly premium investment, now there is $310. Year 3 the S&P goes up 20%, your investment receives a ceiling credit of 12%. Your bucket for that month is now $347.20 (again, never to go down).

Here’s the beauty of this program, similar to what we were told as kids in the story of the tortoise and the hare, slow and steady wins the race. Let’s compare the numbers assuming the S&P returns from above with the $100 going into a 529 or an SIUL.

YearS&P Return529SIUL

00100100

110%110110

2-15%93.5110

320%112.2123.2 (credit ceiling of 12%)

Do you see the beauty of this program? The reason it works is that it NEVER incurs a loss. Since there are no losses, you need not have large gains to offset any losses from prior years. Think back to 2008, the S&P had a loss of just under 39%, let’s say 40% for illustration purposes. With $1,000 starting at the beginning of the year, by the end of 2008, you’d only have $600. To get back to $1000, you would need a single year return of 66.7% or you would need 5 years in a row of 10.76%. With this concept, the 5 years of 10.76% would provide a balance of $1666. Which would you rather have $1000 and deal with ups and downs in the market or $1000 minimum and no concerns about the downs in the market?

You’re thinking this is too good to be true. There are some facts that are important in considering a SIUL as part of your financial strategy, be it for college or otherwise. Earlier, mentioned was a MEC, which is a situation that makes this concept a taxable event, something we do NOT want to happen. To avoid this, you must not overfund this contract. That should be easy enough.

Also, this program requires a minimum payment be made. In the illustration provided here, the minimum monthly payment is $170.75. Failure to maintain this monthly payment would cause the policy to expire and making the program a MEC, a taxable event. Note, if you were not to take loans on this policy, had for the most part funded it at a minimum level, the program would not have a significant impact since there would be little to no taxation involved. But this is not the intent of the program.

There are changes the insurance company can make on this policy that may fluctuate. Included are:

-Premium expense charge (Yrs. 1-5 only)- Expense charge $466/ year

-Cost of Insurance (varies by age) - Loan interest charges (factored into the example)

-Ceiling credit factor – illustration at 10.75% (guaranteed to be no lower than 4.0%)

-Fees, rates and limits are for the example provided.

While the company has the right to make adjustments to these charges, fees and conditions, it cannot be arbitrary, meaning that it cannot select your policy out to do so, but must do to all policies of this type. Additionally, the carrier must file with each state insurance commissioner where it wants to make changes. More prevalent than making changes to existing contracts, most insurance companies file for a new product offering. It cannot be said the costs associated with your policy will not go up, experience shows this is not highly likely. Utilizing the policy by taking loans for college expenses or for other reasons will reduce the death benefit of the policy.

Let’s compare values and impact of a 529 vs anSIUL. Assume .you invested starting in 1998, experienced returns mirroring the S&P 500 beginning in 1998 through 2011 and had 6.0% for the next 4 years (this makes 18 year of savings-our initial discussion point). A 529 would have $4620 a year ($385 a month) invested and the IUL due to fees would be less (and has a 10.75% ceiling). At the end of 18 years, the 529 would have $125,752 and the IUL would have $132,477. The SIUL wins by $6,905 or 10%. (Table 1).

Hands down the SIUL is the ending number winner. More importantly is what is the impact on college funding? Remember, the 529 is counted by public institutions as an asset of the parents and is used to lower how much financial aid a student may be able to qualify. Assuming the $125,752 is the amount of assets that will be assessed as capable of paying for college, the assets alone will dictate the parents need to spend 12% of that amount or $15,090. If the funds were in the SIUL, the amount based on comparable assets is $0. Over a 4 year college education, the parents would have been assessed that they would need to pay from these assets alone $60,360 prior to any eligibility for financial aid. The amount from the IUL concept over 4 years is $0. You decide.

To sum up, let’s do a side by side comparison of 529s vs.SIULs.

Item529SIUL

Tax deferred growthyesyes

Tax free earnings if used for collegeyesyes (a)

Federal gift tax eligibleyesno

Potential tax deductionsyesno

Can be used in any statemaybeyes

Use for anybodyyesyes

Protected from lossnoyes

Hidden from Financial Aid calculationnoyes

Favorable federal estate tax treatmentYesNo (b)

Can use for other purposesYes (c)Yes

(a)IUL must remain non-MEC contract

(b)IUL death benefit is income tax free, but included in estate value

(c)529 used non-education purposes subject to 10% federal penalty and income taxes on earnings

The 529 has its place and can the right solution depending upon circumstances, just like an IUL may be the best solution for a different situation. Beyond these two methods, there are a number of other ways to accumulate funds for college expenses.

Rather than assuming that the most frequently touted solution to a need is the best or most appropriate, investigate the options to determine what option(s) is(are) suitable for you. That’s where I can help in laying out the options, generating comparative data and answering questions regarding the various alternatives.

I hope this discussion has been enlightening and will start you looking at options so that you can make an informed selection.