Life Insurance for Your Child? You Must Be Kid-ding.

So you and your spouse got married, enjoyed a few years together and then in nine short months, out popped an adorable 18-year commitment. And as the new and improved “you,” one thought has likely crossed your sleep-deprived mind, “do I need a life insurance policy for my kid?’” And it’s a fair question to ask. Because as you bottle-feed the most precious bundle of joy to ever keep you up at 3:42 am, you want to ensure you’re doing anything and everything to give your child the best possible life.

And whether your child is two months or two years, the answer to whether or not they need life insurance is: likely not.

Simply stated, life insurance is only an attractive decision if others are dependent on the policy owner’s income. And, unless your child is the next Mickey Mouse Club superstar, it’s unlikely they are bringing home the bacon that your family may depend on.

That said, there are a handful of rare occasions to consider life insurance for your child. But even then, it’s important to read the fine print. If your child were to, heaven forbid, acquire a rare illness that might disqualify him/her for future coverage, you might want to consider life insurance. However, be careful to examine such a policy closely, because the average cost of fighting many complex (genetic) illnesses often exceeds the “ceiling” on what an insurance policy would pay out. So, even if you were covered, you might only be “covered” for a fraction of the total need.

The reason we bring this up: Some insurance companies, are stepping into the savings game with promises of “college savings plans” to position your kid for success. But, when you do the analysis, many of these plans are likely to be a far less-effective option when it comes time to collect your returns.

So, before you dump your hard-earned income into opening a life insurance policy for your child, think about how else you might spend that money to position him or her for financial success. A number of insurance vendors may argue that a certain type of insurance policy is a great way to save for your child’s college fund. But, when deciding on college savings, make an apples-to-apples comparison. Insurance vs. any other types of savings. The question: Do you dish out $300 dollars per month to cover the cost of insurance premiums, or direct that same $300 into an investment account/bank account? Just remember, you bleary-eyed bottle wielder, insurance isn’t free.

When evaluating an insurance policy, find out how much of your premium actually goes toward your child’s savings (the cash value) versus how much of it goes toward the cost of insurance. This number can vary widely, but as an example, let’s say that for every $300 you pay into an insurance premium, $250 goes toward college savings and the remaining $50 covers the cost of insurance. On the flipside, with a standard investment, for every $300 saved, $300 goes toward college. This difference in cost compounds over time: using a 5% return** for each option, in 20 years you would expect the cash value on your child’s policy to increase to $123,310 while the investment account would grow to $143,862.

Cost is not the only factor when comparing insurance and other options as a college savings vehicle. Look at the rate of return. Most cash value insurance policies state a guaranteed rate of return on the policy. This return may seem attractive – after all, it’s guaranteed – but make sure to compare it with what you might earn elsewhere.  For example, the average annual return of a 70% equity/30% bond portfolio over 20 years is 9.79%*. Let’s assume that you find an insurance policy where the guaranteed rate of return is 5%. Remember from our previous example that with a 5% return, the cash value on your child’s policy is expected to increase to $123,310 in 20 years. With the return 9.78% return historically achieved by a 70%/30% investment mix, your child’s account would have grown to $258,653 over the same period. Quite a difference.

To be fair, the return in the investment account comes with risk and is not guaranteed.  The ups and downs experienced from this choice will likely be more significant. But remember that your child’s education is likely a savings goal that is ten, fifteen, even twenty years away (grad school, anyone?). If you set your expectations and understand that time is on your side, any short term volatility should be much easier to tolerate. Especially in-light of the end result.

So, while there are many good reasons to take out an insurance policy, saving money for college may not be one of them. If you need insurance, buy an insurance policy. That’s what it’s made for. If you seek investments as you save for college, consider using a tool specifically designed for investment.

If you plan to utilize need-based aid to help fund tuition, understand that there is also a difference regarding how insurance assets and many savings vehicles are reported.  Non-Retirement accounts, Coverdell IRAs and 529 plans are counted as eligible assets on the Free Application for Federal Student Aid (FAFSA) forms, meaning these assets might reduce the amount of aid you can receive.  The cash value of an insurance policy is not counted on the FAFSA as an asset, although any (non-loan) distributions used to pay for tuition will be counted as income.  Aid eligibility is highly dependent on income and a variety of calculations, so it pays to know the rules.  As always, speak with your advisor.

All this said, there may be one counterintuitive instance in which purchasing insurance as a mechanism to save for your child’s college may actually be a smart choice: the behavioral element. Some experts believe that a layman investor may be less likely to miss an insurance premium than a $100 monthly savings goal. If this is the case, the apples-to-apples comparison above favors insurance. You would pay $1,200 a year in insurance premiums but maybe only save $800-$900 if you accidentally miss a few months. The thing is, from a behavioral perspective, if consistently saving money is difficult for you, by buying insurance you are mentally trapping yourself into executing your goal. Silly, but maybe effective. As always though, working with the right financial advisor can help you elevate your decisions from “silly but effective” to “strategic and effective.”

For a complimentary analysis of which college-savings tool may be right for you, give us a call at 800-331-8936 or simply fill in our “Let’s Talk” tool on the right sidebar.

*Source: Ibbotson & Associates Stocks, Bonds, Bills and Inflation Yearbook, 2014. Returns measured over the period 1926-2013. Large company stocks are represented by the S&P 500 Index. Long-term Government Bonds are constructed with the data from the Wall Street Journal.

Any opinions expressed in this article are general in nature and cannot be guaranteed to be suitable for every individual.  Tax laws and regulations change frequently.  Individual needs and situations vary, talk to a financial advisor to help you consider what options might be right for you.

Past performance does not guarantee future results.

** Hypothetical rate of return

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