The Multi-Pronged Approach to Paying for Your Child’s EducationBeau Ruff
As higher education costs continue to rise, it’s important to consider how best to fund your child’s or grandchild’s education. I propose a multi-pronged approach to utilize tax-advantaged 529 plans, trusts, and term life insurance. The 529 plan offers great long-term savings capability, but in the event of a worst-case scenario, a trust with life insurance funding provides a safety net for the children.
Let’s start with a young couple with young children. Assume that couple has limited resources proportional to their age and new family support obligations. That young couple is also smart and wants to plan to take care of their children’s anticipated (and ever-increasing) college tuition.
Start with the 529. The 529 plan is a state-sponsored tax-advantaged investment account. The parents make contributions to the 529 plan that can both grow tax-free and be distributed from the account to pay qualified educational expenses free from federal income tax as well. The 529 account contributions are generally invested in an investment account (a diversified portfolio of stocks and bonds, mutual funds, or Exchange Traded Funds). 529 plans are an excellent choice to begin saving for college for the children. But, the young couple probably anticipates contributing a smaller amount over their children’s early life (think, for example, an 18-year funding plan). That means that, at least early on, there will not be enough assets in the 529 plan to pay for college and the child may have to utilize scholarships or loans to make up the difference.
To plan for the worst-case scenario of a premature death of the parents, the couple should consider a safety net that a trust combined with term life insurance can provide their children.
Add a Trust. The young couple would next want to update or establish their estate plan and get a new Will. The Will provides that if the parents pass away, their assets will be held in a trust for the children. The terms of the trust will generally provide that the trust assets are used to provide educational opportunities to the children as well as providing basic housing, transportation, food expenses, etc. The difference here is that the 529 plan is funded using current contributions while the trust would be funded using any other assets the parents might have – assets like a house or car. Of course, this trust would only come into existence and be funded with the proceeds from the sale of the house or the couple’s car in the unfortunate event of their untimely death. But, this would provide additional resources to help provide the funds necessary to pay for the children’s education where the 529 assets were insufficient.
In many circumstances, the total assets owned by the couple might still not be enough. Perhaps they just purchased the house, and the equity is still quite low. Perhaps the cars or other assets aren’t worth much either. The couple could then consider using term life insurance to provide adequate funding for the trust.
Purchase Term Life Insurance. To make sure that there are enough assets to properly fund the trust, the couple would shop for, and acquire, a term life insurance policy. Like all life insurance policies, it pays out an amount of money upon the death of the insured person(s) – in this case, one or both parents. Term life insurance is usually cheap to acquire, especially in this case where the proposed insured couple is young (and commensurately healthy). By way of example, perhaps the couple decides in the first step above that they can fully fund the 529 plan in 15 years. Well, then maybe they decide to purchase a 10-year term life insurance policy to provide the funding shortfall if they don’t survive to be able to make all the contributions to the 529 plan. Of course, the parents would generally want to have life insurance to provide coverage not only for college education but also for the costs of raising the children and other costs outside of education should they suffer an untimely death. But, those considerations are for another article. Suffice it to say that a larger term life insurance policy can go a long way in offering the funding to take care of the couple’s children in a variety of circumstances.
What about the grandparents? This article has focused on the young couple so far, but grandparents have options as well. They too can contribute to the same 529 plans. And, perhaps they are in a better place financially. The law allows them to contribute up to 5-years’ worth of annual gifting to each child’s 529 account ($75,000) and elect to report it proportionately on each of the subsequent 5 years ($15,000 per year in this example). Grandparents too can divert some or all their assets into trusts for their grandchildren’s education, just like the parents can. However, life insurance generally stops making as much sense for the grandparents as a funding tool for their grandchildren’s education so the grandparents would instead rely upon the current estate value.
This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect actual current or future interest rates. The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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Prior to investing in 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing. Non-qualified withdrawals may result in federal income tax and a 10% federal tax penalty on earnings.