Some people think of life insurance as an investment. That’s the wrong way to think about it in general, and the same thing goes for life insurance for children.
Most life insurance for children, like the Gerber life insurance you’ve probably seen a commercial or two for, is whole life insurance. At PolicyGenius we don’t recommend whole life insurance for a few reasons; namely, it’s a lot more expensive than comparable term life insurance coverage.
"I know that!" you might say. "That’s why I want to get life insurance for my child! I want a cash value policy to use as an investment vehicle!"
Confused? Here’s how it works.
Some life insurance policies – universal, whole, and variable – have a cash value. That is, you get life insurance with a death benefit, but part of your premium payments fund a cash account that in theory should grow in value over time.
That’s why some parents find life insurance for their children appealing: they get protection and interest-earning savings at the same time.
But the truth is that life insurance for children just isn’t a good investment vehicle.
Depending on the kind of whole policy you buy, the cash portion earns interest from the life insurance company's investments, or at a predetermined rate set by the company, or in some cases from dividends of the company's annual profit. And some whole life policies guarantee a minimum cash value, while other types don't.
Take a look at this chart of a sample whole life policy that pays dividends and offers a guaranteed minimum cash value. It comes from a thread on Reddit with a user asking if whole life insurance is a good investment for his children. (For the record, the other users agree that it’s a terrible idea.) The user points out that at year 19 – around when his child will be going to college or otherwise starting his adult life – the cash value is greater than the premiums paid. That means he’s making a profit, right?
Not exactly. That’s the potential cash value. The other column is the guaranteed cash value, which is half of the premium payments. In fact, the guaranteed cash value isn’t greater than the paid premiums until year 57! That’s a terrible return and a terrible use of your money.
When you invest money normally, you choose what you do with it. You can take it to a fund manager who doles out high fees, or take it to a place like Vanguard and invest it in a low-fee index fund. You can choose what types of funds you invest it in.
With whole life insurance, administrative costs are almost always higher than what you’d pay at a financial institution, and you have no control over where you’re putting your money. Plus, you’re likely average a higher rate of return investing that money on your own than in a whole life insurance policy.
So while it seems like you’re killing two birds with one stone – insuring your child and investing – it’s more like you’re getting an unnecessary insurance policy (with expensive coverage) and a half-baked investment vehicle (with high fees and low growth).
So if life insurance isn’t a good investment vehicle for your kid, what is?
If it’s college you’re concerned about, consider a 529 plan. They’re made exclusively for higher education costs, and have some nifty tax benefits, too.
If your child is old enough to be earning money, maybe with an after-school or summer job, you can manage an IRA for her and match her earnings with contributions, giving her a head start on retirement.
If you’re concerned about him getting a head start on saving in general, open a custodial account for him. You can invest like you normally would, and hand the account off to him when he turns 18 or 21.
If you absolutely feel like you need life insurance for your child, go with a simple term life insurance plan. It’ll provide sufficient coverage for a low cost. But avoid thinking of life insurance as an investment vehicle. It won’t pay off.