Life insurance for children is often marketed to parents and grandparents as a way to create a financial foundation for someone from a very young age and provide peace of mind.
Children's life insurance is a whole life insurance policy that's purchased by an adult and later transferred to the child when they're older.
But is it the best place to put money with an eye toward the future? And what are the potential surprises you might not see coming? Here's what to know.
Taxes on life insurance for children
Children generally cannot "own" life insurance policies, so whoever buys the policy is the policy owner -- typically a parent or grandparent. When the child is age 21, the parent or grandparent will presumably transfer policy ownership.There are a couple potential pitfalls here. The transfer of ownership can trigger the federal gift tax. Or, if the policy owner dies before ownership is transferred to the child, the child's life insurance can be counted toward the owner's taxable estate. While federal estate taxes don't apply to many people because the amount you can exempt is so large, don't forget state estate taxes. Here's a map of state estate taxes from the Tax Foundation.
If a parent owns a child's life insurance policy and withdraws money for, say, college, part of the withdrawal can be taxed as ordinary income. You're taxed on the portion of cash value that came from investment gains, a portion called "in excess of basis." If a parent withdraws money, this income can potentially affect the child's eligibility for financial aid the next year.
Possible tax consequences of owning life insurance on a child
|Transferring the policy can trigger gift tax||When you transfer policy ownership to an adult child, it may trigger a gift tax if it's worth more than $15,000.|
|Owning the policy means it can count toward your estate||If you own the child's life insurance at the time of your death, it can be counted as part of your estate. Federal estate tax applies to very few people, but don't forget state estate taxes. The 2018 federal estate tax exemption amount is $11.2 million for individuals, $22.4 million for couples.|
|A portion of money withdrawn from the policy can be taxed as income||If the policy owner takes out money from cash value, the portion based on investment gains is taxable.|
Dissecting the sales pitches around life insurance for children
Here's a look at three common sales pitches for children's life insurance.
Pitch No. 1: The policy provides life insurance protection
How it works: If a child dies the life insurance death benefit goes to whoever is named as the beneficiary. That money can be used to pay for a funeral or medical bills.
What to know: Statistically, children are very unlikely to die. And kids typically don't need life insurance because no one relies on them financially.
Money is likely better put toward buying life insurance for the children's parents.
Pitch No. 2: The policy's cash value can be used to pay for college, start a business or other needs
How it works: Life insurance for children is whole life insurance that builds cash value over time. The cash value grows at a guaranteed rate of return. The policy owner can access the cash value by withdrawing money or taking a loan against it. This money can be put toward anything, such as college or a car.
What to know: While there is a guaranteed rate of return on the cash value, some of the premium paid goes toward the cost of the insurance and fees. If your goal is to provide college money in the future, you could set up a 529 college savings plan, start a money market account or use another savings method. Others savings methods provide a better investment because you're earning gains on all the money.
Withdrawing money from the policy will reduce the death benefit, as will any loans against the cash value that aren't paid back.
Pitch No. 3: Children's life insurance provides guaranteed coverage and protects insurability
How it works: Children can keep the life insurance policy their entire lives and eventually they can name their families as beneficiaries. They'll have coverage even if health issues would prevent them from buying life insurance as an adult.What to know: It's likely that the child will be able to buy life insurance as an adult. Life insurance is available to people even with medical issues. But if your family has a genetic history of disease, children's life insurance could be a better gamble.
Also, children's life insurance policies tend to be small -- maybe $50,000. These small amounts are likely insufficient when the adult child has a family, a mortgage and other financial obligations to cover. Even with a policy from childhood they'll likely have to buy a much larger policy to cover needs.