What's Wrong With Variable Life for College?

Before I dissect VLI, let's make sure we understand its parts. Basically, it offers life insurance coverage combined with a tax-deferred investment feature. Your premium payments are spent on three things: 1) the cost of the life insurance, 2) various insurance company fees -- including sales charges, which are deducted from each premium payment and 3) your tax-deferred investment account. Whatever amount is left after the first two goes into the third. And that amount is probably a lot less than you would hope.

You can allocate your investment-account dollars among a variety of "subaccounts" or "portfolios." These subaccounts look a lot like mutual funds. For example, the John Hancock Variable Life Insurance Company's most popular policy offers 24 different subaccounts, ranging from "growth and income" to "international equity index" to "money market." The subaccounts are basically identical to John Hancock mutual fund products bearing the same names. Here's how it would work. Say you are a 35-year-old male in excellent health, planning for the college education of your three-year-old daughter. Plus you need some more life insurance. If you bought a $500,000 VLI policy from John Hancock, you would pay $5,000 in annual premiums for 15 years, for a total cost of $75,000. When you turned 50, your child would be ready to enter college and you'd be prepared to pay the bills -- because your tax-deferred investment account would be worth $121,000 -- assuming the same 8.82% annual return that John Hancock does in its policy illustration.

You could then get your hands on, say, $100,000 of the account value without paying any income taxes. How? By withdrawing $25,000 each year for three years (the $75,000 tax basis of your account) and taking out a policy loan for another $25,000 in the fourth year. Your net investment-account balance would be about $39,000 after all this. If you met certain requirements, you could deduct at least part of the policy-loan interest expense under the tax rules for college loans (see story).

Finally, you'd also have $500,000 of paid-up life insurance coverage at age 50, which would cover you until you turn 100. So if you died prematurely, the $500,000 death benefit would foot your child's education expenses and then some. And it wouldn't be subject to income taxes (there could, however, be an estate-tax hit, depending on your circumstances).

Providing you survive, you could rebuild your investment account by gradually repaying the policy loan after your college-funding challenge has run its course. Eventually, you could liquidate the account -- and pay the resulting income taxes -- to help finance your retirement or for any other reason.

Putting the College-Savings Pitch Under the Microscope
As you can see, VLI is a tidy package for parents who want to start a college-savings program and also provide for their own retirement. That's in part because the IRS treats VLI investment accounts almost the same as tax-deferred retirement accounts (traditional IRAs, 401(k)s, SEPs, Keoghs and the like). However, VLI accounts have the added advantage of easier borrowing. There's no borrowing against IRAs, SEPs and SIMPLE IRAs. And while most qualified retirement accounts (401(k)s, etc.) allow borrowing, loans are capped at $50,000 and must be paid back within five years or right away if you leave the company.

So what's wrong with VLI? For one thing, the premiums are nondeductible. And the expenses will eat you alive. Let's run some numbers and you'll see what I mean.

Say our 35-year-old male (excellent health, no history of tobacco use) doesn't go the VLI route. Instead he buys John Hancock's $500,000 15-year, level-premium term life policy for a mere $260 annually. Then he plows an extra $6,580 into his 401(k) each year for 15 years. For someone in the 28% tax bracket, the annual tax savings are $1,840. So the actual after-tax outlay is $5,000, exactly the same as for a VLI policy. Assuming the same 8.82% rate of return, our friend's tax-deferred 401(k) college-savings fund is worth a whopping $204,000 after 15 years -- probably enough to send two kids to college. Compare this outcome to the $121,000 that would accumulate in a tax-deferred VLI investment account after 15 years. (Part of this huge advantage will eventually go to pay taxes on your 401(k) withdrawals, but you still come out way ahead.)

Of course, not everyone can make enough additional deductible retirement-account pay-ins to meet his or her college-funding needs. If you've already maxed out your contributions, do this. Pay the $260 for the $500,000 term life policy and invest $4,740 in a taxable account. Again, your annual outlay will be the same $5,000 you would pay for a VLI policy. After 15 years, you'll have about $131,000 if you can earn 7.5% after taxes. That really shouldn't be too hard if you invest in tax-efficient funds. If you can earn 8.5% after taxes, your college account will be worth about $137,000.

Notice that with our do-it-yourself strategy, your term life coverage runs out after 15 years. If you still need insurance at age 50, you could buy another $500,000 15-year, level-premium term policy for $930 annually (at current rates and assuming continued good health). That would cover you through age 65. In present dollars, the second policy costs about $9,000. So let's take that figure right off the top of our college-savings fund. In the 401(k) example, you still end up $74,000 richer ($195,000 compared to $121,000). Using a taxable account, you'd still be slightly ahead if you earn 7.5% ($122,000 compared to $121,000) and well ahead if you can manage to earn 8.5% ($128,000 compared to $121,000). After age 65, you really shouldn't need continued life insurance coverage if you've done a good job of retirement planning.

There's another important advantage to our do-it-yourself program. Say you take the taxable-account route and earn 8.5%. But you die the day after you turn 50. Your heirs will collect $628,000, because they get the college-savings account money ($128,000 net of life insurance costs) plus the life insurance death benefit ($500,000). But with VLI, there's no double dipping. Your heirs get only the $500,000 death benefit. Your hard-earned VLI investment account simply vaporizes if you are unlucky enough to die prematurely.

Why does VLI lose every time? Because the insurance company hits you with lots of expenses. With the John Hancock policy, each $5,000 annual premium includes a $256 sales charge (5.12%) for the first 10 years and $180 (3.6%) for the last five years. There's also an administrative charge of $312 in the first year and $72 thereafter for as long as you own the policy. During the 15-year pay-in period, $4,780 goes just to pay those charges. After deducting another $13,100 for life insurance, only about $57,000 -- of the $75,000 in total premiums -- actually makes it into your investment account.

With VLI you also have to worry about surrender charges. If you want to bail out of your investment account before the 13th year, you'll be penalized. For instance, exiting in the fifth year means you get only about 78% of your account value. Surrender charges after the ninth year are pretty minimal but nevertheless annoying. The bottom line: Surrender charges make VLI unattractive for college savings unless your college-bound child is quite young.

Rustling Up College Cash Without Triggering a Tax Bill
As the earlier examples show, setting up your college-savings program inside a tax-deferred retirement account is the preferred strategy. Unfortunately, there's one big problem here. At college time you want to get your hands on the necessary dough without being taxed, but you can't take retirement-account withdrawals without paying Uncle Sam. So let's explore other nontaxable ways to free up the needed cash without actually dipping into your retirement accounts.

As mentioned, you may be able to borrow up to $50,000 against your qualified retirement plan account at work. The interest is nondeductible. That's OK since you are basically paying the interest to yourself. However, you must repay your loan in five years. And if you leave the company, you'll have to pay it posthaste.

You might also be able to take out a margin loan against your taxable investment accounts and deduct the interest under the college loan rules. Ditto for loans from other sources used to pay college bills.

Finally, you can generally borrow up to $100,000 against the equity in your home and write off the interest as an itemized deduction. (Beware: Your deduction will be wholly or partially disallowed if you owe the dreaded alternative minimum tax.)

As you can see, these schemes involve: 1) saving for college in a tax-deferred account, 2) borrowing what you need when the bills come due to preserve your tax-deferral advantage and 3) gradually repaying yourself by paying off the loan. As a CPA, this strategy sure makes sense to me.

Remember that you can also make nondeductible contributions to a Roth IRA (assuming your income isn't too high to qualify) and earn tax-free (not just tax-deferred) income. At college time, you can take tax-free withdrawals up to the amount of your contributions because they were made with after-tax dollars. No borrowing required here, although I'm not very enthusiastic about this idea. Why? Because there's no way to get the withdrawn money back into the Roth account -- meaning your capacity to earn future tax-free income is permanently reduced.

If you must use taxable accounts for your do-it-yourself program, you can still achieve tax-deferral by carefully managing your investments. Obviously, if you bought Microsoft a few years ago and just sat on the shares, you've paid hardly a dime in taxes so far. When you eventually sell some shares to pay college bills, your profit will be taxed at only 15%. If you sell some losers at the same time, you may not owe anything. Another way to completely avoid any current taxes is by keeping your shares and taking out margin loans to pay college expenses. Investing in equity index mutual funds and tax-efficient funds won't result in 100% tax-deferral, but you may be able to come pretty close.

Another alternative for maxed-out folks: state-sponsored college savings accounts, also known as Section 529 accounts. Some allow you to invest more than $250,000 in a child's account and the earnings on these tax-deferred accounts are tax-free when withdrawn to pay qualified college expenses.