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529 Education Plans September 17, 2015

Posted by shaferfinancial in Finance.
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A client has asked me to review my thinking on 529 Education plans. Specifically, he asked that I compare them to using an EIUL for college funding. As many on this blog know, the issues of 401Ks funded with mutual funds used for retirement income are rarely talked about in the popular press. Those issues don’t go away if you change the wrapper to a 529. So most of the issues are the same plus one more big issue.

Sequence of return risk is the same as in a 401K. What happens if the market takes a dive right before your child needs to use the money for college? Well, you end up having much less than you thought you would have for college. What are the odds of this happening? If history is a guide well over 70% as the average bear market occurs every 4-5 years. To account for this most companies use “target funds” which increase the bond percentage in the fund as you get closer to the target date [estimated first year of college]. The problem with target funds is that by decreasing the equity coverage you decrease the average returns. The other issue is that bond funds can also decrease in value at the same time [as we found out in 2008-09]. The end result is that you have to be lucky [real lucky] to not have an issue with these 529 funds.

Many think they can be proactive with the funds and get the money out of funds if the market starts going bad. Studies have proven that individuals are really bad at this strategy universally. And many find that they can’t just sell their funds inside a 529 like in a 401K. Bottom line is that you have a really good chance of getting “stuck” in a fund that has huge downward variability when you have a drop dead date for using the money. Never a good strategy.

Next is that the funds must be used for educational purposes. Now I know every parent thinks their kid is an academic superstar and will end up at Harvard [tongue in cheek], the reality is that over half [65%] of them will not graduate from a accredited program. And if you don’t use the funds for education you need to pay taxes on the principal and the gains. I know this is tough to imagine for many, but there are a whole lot of folks that would be much better off not wasting their talents at college. There are many really lucrative occupations that kids would find meaningful that don’t require college. Having that money sitting there could encourage those kids to waste the funds sitting bored in a college classroom instead of finding their way in life.

Finally, putting money in a EIUL instead does 3 things. It eliminates sequence of return risk increasing the likely average return for that day they leave for college. It eliminates the possibility of taxes if the choice is not college. It creates a fund that can be used for a variety of things, from a car, to a down payment of a house, to college that can be turned off if they want to defer after a year of classroom boredom or even a trip to see the world. And it also creates a “bank” that the offspring can use “for the rest of their life.”

Borrowing out of a EIUL policy can be done two ways. The first is cost free and the second variable type loan allows for arbitrage against the interest credit. So you can actually make money on the distributions you have already used [historic numbers point to a 2-3% advantage over the long run]. The compounding continues as long as you have the policy using a variable loan in your life insurance policy.

So here are the five takeaways:
1. An EIUL offers greater flexibility
2. Sequence of return risk is eliminated
3. Positive arbitrage of funds is a real possibility
4. Life time bank that can be used, replaced or not, and used again
5. Likely greater return in an EIUL than the funds inside a 529 wrapper.

And here are two additional benefits:
1. Underwriting is done at an early age so diminished health is not an issue for obtaining life insurance at a later age
2. You control the policy and aren’t at the whims of the government telling you how you can use your own money

So what are the negatives????

1. EIULs are not made for short term thinking. If you surrender your policy in the first 10 years you are likely to not get all of your principal back.
2. To use the policy efficiently you need to keep it for life [or pretty near] and you need to plan ahead how much premium you are going to put in.
3. The total costs for the life of a policy are going to be between .25 and .4% on a child. There are many mutual funds that have lower total expenses.
4. You need to only purchase the policy from a financially stable insurer [top rated], because it is the insurer who is backing your policy.

I let the reader decide which makes more sense.

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