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Shifting Assets to Qualify for Federal Student Aid

| October 01, 2015
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Should you shift assets to life insurance to qualify for financial aid?

I have recently spoken to several clients and friends who have gone to see a college planner. The college planner has suggested shifting assets out of 529 college savings plans and other college savings vehicles into cash value life insurance to help qualify for financial aid. Should you consider this strategy?

To better answer this question, first we need to take a closer look at financial aid. There are two types of aid: need based and merit based.  Need based aid has to do with your finances, merit based aid has to do with your kids' athletic, musical, or academic excellence.

For need based aid, you can go to the FAFSA calculator on the Federal Student Aid web site to get an estimate of your eligibility for federal aid: FAFSA 4caster Tool

  • There are a number of criteria that must be met to be eligible for federal student aid including:
  • Be a citizen or eligible non-citizen of the United States.
  • Have a valid Social Security Number
  • Have a high school diploma or a General Education Development (GED) certificate, or have completed homeschooling.
  • Be enrolled in an eligible program as a regular student seeking a degree or certificate.
  • Maintain satisfactory academic progress.
  • Not owe a refund on a federal student grant or be in default on a federal student loan.
  • Register (or already be registered) with Selective Service, if you are a male and not currently on active duty in the U.S. Armed Forces.
  • Not have a conviction for the possession or sale of illegal drugs for an offense that occurred while you were receiving federal student aid (such as grants, loans, or work-study).Source: FAFSA.ed.gov

The calculator will estimate your family’s expected family contribution (EFC) which is defined as: “a measure of your family’s financial strength and is calculated according to a formula established by law. Your family's taxed and untaxed income, assets, and benefits (such as unemployment or Social Security) are all considered in the formula. Also considered are your family size and the number of family members who will attend college during the year.” (FAFSA.ed.gov)

If your expected family contribution is more than the cost of the school you will not qualify for any need based aid. If this is the case, rearranging assets to qualify for aid does not make sense.

However, if your expected family contribution is less than the cost of the school, you will likely qualify for need based aid (could be grants, student loans, or work study).  For federal aid, certain assets are included in their calculation:

For Federal Aid:

  • Assets include: money in cash, savings, and checking accounts. Businesses and farms, investments that you own such as stocks, bonds, CD’s, and real estate
  • Assets do not include: your primary residence, life insurance, retirement plans such as a 401k

Therefore if you think you will qualify for federal student aid it may make sense to rearrange assets. 

This brings us to the possible use of life insurance cash value for college.  Here are the benefits of cash value life insurance:

  1. It has a death benefit, so should you die during the policy’s term, the death benefit could be used by your survivors to pay for college expenses
  2. It has flexible premiums so you could contribute a lump sum or periodically, or both
  3.  You may be able to add a waiver of premium option that makes the premium payment for you if you become disabled.
  4. The death benefit may also be flexible and could be reduced once the child finishes school thereby reducing the cost of the policy
  5. Deposits earn a modest interest rate and accumulate as cash value
  6. Cash value of some life insurance policies such as universal life do not fluctuate up and down with the stock market
  7. Cash value grows tax deferred and the cash value can be borrowed at stated interest rates.
  8. Life insurance is excluded from the Federal calculation for need based aid as discussed above
  9. If you qualify for federal student loans such as the Stafford loan, you could allow loan balances to accrue with no interest while your child attends school and then pay the loans down using cash value from the life insurance as soon as your child graduates

What are some of the disadvantages of life insurance?

  1. Policy fees – some policies have an annual fee or front end sales charge
  2. Premiums to cover the cost of the death benefit – you may not need additional life insurance if you already have coverage privately or through a group policy
  3. Some states charge state premium tax of 2-3% annually
  4. Surrender charges as high as 10% and lasting up to 10 years. Each new premium may carry its own surrender charge

How can you get money out of your policy?  There are two ways to get money out: loans and withdrawals.

A withdrawal reduces the cash value and is subject to surrender charges and the available cash value of your policy. Withdrawals in excess of your cost basis are taxable as ordinary income but withdrawals less than your basis are tax free.  

When you take a loan against the cash value of the policy, you are not reducing your cash value.  You are taking a loan using the cash value as collateral and you will be charged interest on your loan which compounds over time. If you do not pay the loan plus interest back, any money taken out will be deducted from the death benefit

You must keep the policy in force by continuing to make minimum payments. Failing to make minimum payments will deplete cash value and eventually cause the policy to lapse.  If the policy lapses, your loan becomes taxable as ordinary income to the extent the loan exceeds your basis.

If cash value becomes too large relative to the death benefit, the policy will no longer qualify as a life insurance policy and will instead be considered a modified endowment contract causing the owner to report annual gains as taxable income.

 

Conclusion:

Shifting assets from a tax free account such as a 529 into a tax deferred account such as life insurance will result in higher taxes being owed.  You will pay a 10% penalty to the IRS for taking money out of a 529 plan that is not used for qualified educational expenses. Taking withdrawals from the life insurance policy may trigger surrender charges if the policy has been in force less than 10 years.  Loans may trigger interest and higher premiums if you plan to keep the policy for your entire life.  While there is a death benefit and protection from disabilities through a life insurance policy, these benefits carry costs which may be unnecessary if you already have life and disability insurance through a group plan or privately through term life insurance. Finally, if you do not qualify for need based aid, shifting assets to hide them from the FAFSA calculation is not relevant and will not benefit you in terms of qualifying for Federal Student Aid.

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