3 Reasons to Avoid Life Insurance Policies for College Savings

Once their child is born, parents are often bombarded with literature and advertisements touting different methods to save for college. And with the promise of guaranteed rates of return, cash-value life insurance policies are often pushed to eager, college-planning parents.

These policies accumulate value during the policyholder's life and then pay out upon his or her death. But policyholders can also make withdrawals or borrow against their policies during their lifetime and use the money for college expenses. Unfortunately, many parents don't realize until later -- when premiums continue to rise and erode cash accumulations, or when withdrawals become difficult -- that life insurance policies aren't the best college savings vehicles after all.

Here are three things that experts say can cause problems for those using life insurance policies to save for college.

[Learn three ways to make the most of a late start on college savings.]

1. Agent practices: Insurance agents typically generate their income via sales commissions. As a result, says Lake Mary, Florida-based financial planner Carlos Dias Jr., "commissions frequently interfere with the way a life insurance policy is structured and most of the time the wrong product is used." Dias says there are several life insurance companies that allow agents to take reduced commissions, which puts more money into the policy for its holder -- but that's rare.

"If a life insurance policy had a minimum death benefit -- versus higher death benefit -- the policy has a higher cash accumulation because the cost of insurance is a lot lower," says Dias. That's because premium payments increase in proportion to the death benefit. If parents are purchasing a policy with the intent of saving for college, they are less concerned about having a high death benefit. But, says Dias, the majority of policies sold don't take that into consideration.

"In the life insurance industry, agents are paid on target premiums," Dias says. "The higher the target premium, the larger the commission and vice versa, so policies are often sold for the agent's benefit, not the client's."

2. High cost: Even when life insurance policies are structured with the maximum client benefit in mind, they still tend to be much more costly to maintain than other college savings vehicles , like state-sponsored, tax-advantaged 529 plans.

[Figure out if a 529 plan is right for you.]

"Policy premium payments go toward the cost of insurance -- they are cheaper when you're younger and healthier -- plus a policy contract charge, which is usually 5 percent of the premium payment," says Greg Lessard, founder and president of Aspen Leaf Partners, a fee-only financial advising company in Golden, Colorado. "The rest of the payment ends up in your cash value 'bucket.' In a variable policy, the cash value bucket invests in mutual funds, called subaccounts. The average expense of these subaccounts is approximately 1 percent as a cost of investing, just like any mutual fund would charge."

Using an example of $7,500 paid into a policy over the course of a year, Lessard estimates that $1,500 of that would cover the cost of the insurance and $375 would cover the contract charge. The remaining $5,625 would be available for investment -- at a cost of 1 percent.

"If a parent contributed the same $7,500 to Vanguard's 529 plan in Colorado, they'd actually have $7,500 invested, unlike the insurance example where a big portion gets eaten up to policy costs," says Lessard. "Additionally, a no-load 529 plan with a sensible, low-cost investment design would cost 0.19 percent in fund expenses -- much less than the typical 1 percent found in most insurance products."

[Ask these four questions before opening a 529 plan.]

3. Withdrawal burdens: When parents purchase a life insurance policy to save for the child's college expenses, there is an understanding that they will ultimately have to withdraw those funds. But this process often creates unexpected hassles.

"First, parents will have to pay income tax on the difference amount if they withdraw more money than the premium they paid, as well as a potential 10 percent penalty if they are under age 59 1/2," says Joyce Garner, an insurance broker with Zimmerman & Ray Associates in Roseville, California.

Lessard says that there are also issues if parents decide to take a loan against their policy, as opposed to a straight withdrawal, as policy loans charge interest and require a payback schedule. There's also the fact that, if a parent takes a large sum of cash from the policy and still needs the death benefit, the policy may lapse from the lack of cash.

For these reasons, Garner recommends other vehicles for college savings, including 529 plans. "There are significant state tax advantages and other benefits, such as matching grant and scholarship opportunities, protection from creditors and exemption from state financial aid calculations for investors who invest in 529 plans in their state of residence," she says.

She also recommends Roth IRAs, which are also tax-free. Additionally, she says, Coverdell Education Savings Accounts allow parents to save up to $2,000 per year, per child, and can generate tax-free earnings from interest, dividends and appreciation.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.