They come into this world and no doubt change yours forever. We’re moved in ways we didn’t think possible… love them in ways we never imagined. Thus, we are vulnerable to bias’ when it comes to doing them the greater good. We want to do what’s “right” and in their best interest, but when it comes to buying life insurance on a child… what is right? Life insurance is something we all need and should have. But what about buying life insurance on your kids. It seem logical. Heck… there’s even a commercial or two I see every day touting the benefits of buying it on my children. These are the more popular reasons promoted for buying life insurance on your children…
Death of a child
This is a reality and if your child dies you will paying money for a funeral. The average funeral costs between $10,000 to $12,000. The emotional devastation of a child dying has its own expenses as well… lost time at work, the possible need for therapy, and any other number of reasons when grieving. Add to the earlier figure another $10,000. Unless you have cash in savings you’ll be borrowing it. You should buy enough life insurance on your kids to cover any funeral expenses and other costs. Yes… buy for this reason.
Future insurability of your child
This concern speaks to the idea of your child having health problems in the future and is unable to buy life insurance, or must pay higher prices. This is a possibility but how likely is it? If you follow this advice to protect future insurability of your child how much do you buy today…? $100,000, $250,000, or even $500,000 of coverage for your child? It impossible to answer what’s the right amount when using the argument of protecting future insurability. It’s true your child might have adverse health conditions when they’re older. Keep it simple and don’t chase the rabbit with this idea. Protect your child today but don’t try to over purchase life insurance on your child. Consider using your money for building wealth in other areas.
Buying life insurance for the special tax treatment
Life insurance policies have certain special tax treatments. Death benefits are payed out tax free. Cash builds up inside a cash value policy tax deferred (you do not pay taxes on any growth until you pull that growth out). You can take out the initial money you put in before you get to the growth as long as your policy is not a MEC or Modified Endowment Contract (i.e., get your basis first). Sounds great, right? But there are trade-offs. Cash value life insurance is expensive and you end up paying to get this “special tax treatment” inside life insurance. At the end of the day the tax benefits you hope to get can be cannibalized by the less salient aspects of life insurance. Stick to the purpose of life insurance. Buy life insurance to manage a risk not to seek out some special tax benefit.
Buying life insurance as a saving vehicle or an investment
Regarding Whole Life and Universal Life… when you run the numbers the returns are near anemic when compared to other investment options. The nominal rates (returns without inflation factored in) are not much better than the 10 Year Treasury. When factoring inflation (real rates) into the results, you might only break even. You might be told the current rates of returns are 4 or 5 percent but ask what that rate of return is after the cost of insurance is taken out. It ends up being closer to 1 or 2 percent. Only when you build up a substantial amount of cash in the policy can it begin compounding closer to the current rates set by the insurance company, which by the way can be changed down each year until you hit the guaranteed amount in the contract… usually a very low number. Regarding (VUL) Variable Universal Life… VUL allows you to invest into sub-accounts (typically a mix of mutual funds). Yes… this does allow you to participate in potentially higher expected rates of return. Keep in mind however the same cost mentioned earlier exist in this type of policy and create a considerable drag on performance. You have the same market risk but with more expenses. Life insurance is a risk management tool not an investment. There are better ways to save money for your children.
Using Life Insurance as a college planning investment tool
The internet is rife with opinions on this topic. Most revolve around a few ideas.
1) Money inside a life insurance policy does not reduce your financial aid: It sounds great on the surface but beware of the trade-offs for following this advice. As I mentioned above, life insurance as an investment typically does not work out well. Life insurance cash values are slow to grow due to high costs built into the policy. It takes several years to break even. You also have several years of surrender charges. If you buy a policy and try to take money out before a 10 to 20 year period you can suffer big penalties form the insurance company.
Most permanent life insurance policies have a loan provisions. Taking money from your life insurance policy as a loan does not count agains financial aid… but creates interest against your policy. If you take a withdrawal (not a loan) it can count as untaxed income to the beneficiary on the financial aid form and wreak havoc on aid eligibility.
If you buy a policy on you kids at birth you’re 18 years away. Unless the policy builds cash quick – this only happens when you overfund it – your returns are less than stellar. If you overfund the policy some of the tax advantages can disappear. Some things look great on paper, but in reality it’s less appealing.
2) Flexibility of using the money: It’s true, if you use a qualified plan such as a 529 plan, distributions are restricted to qualified expenses. Taking more than is allowed triggers a penalty. If your child chooses not to attend college you can transfer the 529 to another beneficiary. If not, then you are subject to penalties when distributing the money out of the 529 plan.
Life insurance does not have this limitation. You can take as much out as you want without penalty provided the policy meets certain criteria (i.e., it’s not a MEC… see above). If it is a MEC, then it’s treated similar to an IRA when distributing your money. If the policy is in the child’s name and they’re under 59.5 years old a 10-percent penalty is applied… same as the 529 plan.
3) Investment risk: No matter what… all of your money is exposed to some type of risk. If you’re in cash you have purchasing power risk because of inflation. If you invest in bonds you have risk… if you invest in stocks you have risk. Don’t let avoiding risk be the primary reason to buy life insurance as an investment… remember what was said earlier about life insurance as an investment.
Guaranteed does not always mean “guaranteed.” If you have a cash value policy other than a “Variable” policy where you invest in mutual funds you money is part of the insurance companies “General account” and your money is only backed up by the full faith an credit of that insurance company. If they go bust then you are only insured for a portion of that policy.
Where should I buy life insurance for my children…?
Benefits at work
If you have a benefit package at work check there first. Typically you can buy it as a rider to your policy… a very inexpensive option. Other options at work can allow you to buy a stand alone policy on your kids. Check your benefits package first when buying life insurance on your kids.
As a rider to your personal insurance policy
If you plan to buy a policy on yourself from an insurance company or an insurance agent you should be able to insure your kids as a rider on your policy. This is an inexpensive and effective way to get the coverage needed on your kids.
Buy a policy on your kids from the insurance company or insurance agent
You can buy your kids their own policy. This typically cost more but has long-term benefits for your kinds. Be sure to not over-buy the amount needed. Unless you have a unique situation a $25,000 policy should be enough.