Does My Child Need Life Insurance?

Congratulations! You have a new baby in the family! Cue the cute outfits, fuzzy blankets, and life insurance mailers. Wait a second; one of those things isn't warm and snuggly! Why would a child, a baby much less, need life insurance?

Most life insurance policies are purchased to replace income that is lost due to a person’s death. Children are not income providers; however, there are situations when a life insurance policy may provide a solution.

Before shredding those mailers, consider why some people choose to take out life insurance policies on their children and determine whether it is an appropriate strategy for your family.

Life Insurance Basics

When purchasing insurance on a child's life, the most common type is permanent life insurance, also known as "whole life" or "universal life." The child is named the insured person, and the parent(s) are named policy owner and beneficiary. As long as premiums are paid, permanent life insurance remains in place, unlike term insurance, which has a specified end date.

A portion of premiums paid on permanent insurance goes toward the "cash value" of the policy. Depending on the permanent policy type, the cash value grows at a stated rate of return or is invested in the stock market with fluctuating returns. While the parent is typically the initial policy owner, ownership can be transferred to the child eventually.

Concern: Child’s Future Insurability

There are certainly logical reasons to purchase life insurance for a child. One of the biggest "pros" is the possibility of a child developing a health condition leaving her/him uninsurable once she/he becomes an adult and needs coverage. Families with known genetic conditions can find the strategy of purchasing life insurance on children particularly valuable. Turning to current events, some parents have considered this approach due to unknown, longer-term health problems COVID-19 could potentially present in children who have contracted the virus.

Life insurance premiums for children's policies are inexpensive, but the amount of death benefit a child can reasonably qualify for is also relatively low. However, permanent policies can also provide the ability to increase death benefits over time, often without medical underwriting. If future insurability is the primary driver for purchasing life insurance on a child, this is a hard argument to refute.

Concern: Unexpected Funeral Expenses

Another reason to purchase life insurance on a child is the death benefit that becomes available to the parent(s) when a child passes. The death benefit could aid with funeral and burial costs, along with providing financial support for a parent who needs time off work or needs to pay for ongoing counseling.

However, an alternative would be to build and maintain an adequate emergency fund. Instead of paying life insurance policy premiums, consider directing cash towards creating an emergency fund. Ultimately an emergency fund has more flexibility to be used for various unforeseen events, not just the unexpected death of a child.

Concern: Saving for College

Permanent life insurance can be viewed as a forced savings vehicle for future college expenses. As referenced earlier, a portion of premium payments made on permanent life insurance go towards the policy's cash value. Once a child reaches college age, the cash value can be accessed to pay college expenses.

To access the cash value, a policy loan will be necessary. The loan eventually needs to be repaid, or the death benefit will be reduced. Continued premium payment during and after college is also required to keep the policy in force.

Conversely, the cash value can be accessed by surrendering the policy altogether. This action may incur surrender charges and means the policy will no longer exist. Accessing the cash value by surrendering the policy also means income taxes will be owed on any cash value investment gains.

A permanent life insurance policy is no substitute for a 529 college savings plan. Contributions to 529 plans grow tax-free while distributions for qualified education savings are made tax-free, not to mention other tax benefits that might be available depending on state residency.

There are no loans or surrender charges associated with distributions from 529s for qualified education expenses. 529 plan fees are typically lower than those of permanent life insurance policies, while potential investment returns are typically higher. If the child who is the beneficiary of the 529 plan passes, contributions can be accessed penalty and tax-free. Income tax will be owed on the earnings portion, but no penalties.

Accessing the cash value of a permanent life insurance policy for college expenses is not as easy as it may sound at first. If the main reason behind purchasing a life insurance policy on a child is education savings, a 529 plan is most likely a better option.

Summary

Evaluating the main reasons behind a desire to purchase permanent life insurance on a child can be helpful with the question "does it make sense?" If you are protecting against future un-insurability, it's hard to argue an alternative solution. However, if the rationale is to provide for costs associated with losing a child or saving for college, there may be more practical solutions.

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