One of the most effective financial tools you can give a child is an appreciation for an emergency fund and the advice on how to build it themselves.

An emergency fund should contain 3-6 months worth of money to cover living expenses – its main focus should cover all loss of income, not just a car payment or a refrigerator repair. With parents losing jobs and college expenses continuing to grow, the younger you can get a person started, the better. Some advice:

1. Start by encouraging them to save something, no matter how small the amount: Even if it’s a few cents out of an allowance, a teenager should be encouraged to set up a separate savings or checking account – someplace not easy to access – where they can house the money. Interest-bearing accounts are better. For young children, this is why piggy banks work so well. It’s about setting goals and knowing where the money is.

2. Help them develop a balance between treats and sacrifices: Financial independence requires a balance of risk and reward. Life can’t be all about building reserves, so tell the teen when they hit a certain level for the fund – maybe a midpoint toward the three-month mark – they can treat themselves to clothes or an electronic device. After the purchase, they go right back to saving.

3. Encourage them to direct all change into the emergency fund: No matter how old or young the child, it’s a good idea to take non-essential funds and direct them toward the emergency fund. Change is a great way to get started.

4. Set an example: Can your child see you saving? Do you physically set aside money and talk about goals for that money? Your child hears all of this. While parents can’t be perfect, think about the money behaviors you’re demonstrating in front of the kids, and try to make them positive.

5. Keep them away from credit as long as possible: It’s one thing for a teenager to use their parents’ credit card while they’re still living at home. It’s quite another when they get their first taste of freedom hundreds of miles away. Parents may co-sign the student’s credit card but keep it in the student’s name. That way, parents will know when financial missteps occur; this will be a strong incentive for the student to keep his credit rating clean for the next four years.

6. Set up money meetings: Whether the child is living at home or off at school, it makes sense for the parent and child to have a few meetings during the year to talk about the range of money issues the child is facing, and during that time, the emergency fund can be up for inspection and discussion.

7. Make them set up a real budget: Budgeting comes with saving. Young kids can do their first budget on paper – they can track what they spend and save over a month or two and then establish what comfortable amounts for both will be. Teenagers and prospective college students might find it useful to have personal finance software to track their everyday expenses, though they should make sure both the computer and the passwords necessary to access their program are secure.  Again, review these details during your money meetings.

8. Get them interested in better-paying, safe savings vehicles: At some point, the piggy bank’s got to go. An emergency fund can eventually gravitate to other interest-bearing accounts that might pay more, but only as long as the money stays liquid. If the emergency fund is healthy, it’s also wise for parents to talk to their children about setting up their first IRAs to get a jump on retirement planning and considerable tax savings.

9. Remind them that today’s emergency fund may not fit next year’s needs: An emergency fund will almost always need to expand in size as the person ages. More years, more expenses, more emergencies – make time to convince your child that emergency funds should change with life circumstances.

10. Train them to start saving tax refunds: If Uncle Sam kicks back a few bucks, then by all means, put it in the emergency fund or other savings vehicles.

January 2010 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V. Higgins, CFP, CLU, AEP,  a local member of FPA.

One of the reasons parents give children allowances is to help them learn how to manage money.

But for it to be a truly effective teaching tool, parents need to spell out what the allowance will cover, how it can be spent, the consequences of overspending, and how much should be saved or given to charity.

Here are some guidelines:

1. Encourage planning. When deciding how much the stipend should be, consider giving enough to encourage saving or charitable giving. But be careful not to give too much. If the kids can buy anything they want, the allowance fails to teach them how to prioritize and set goals.

Though grandparents are among the millions who have taken a big hit to their portfolios in recent years, careful planning can ensure a healthy contribution to the education and financial future of their grandchildren.

The first step involves a talk between grandchildren and their adult children. According to 2008 research from The Hartford Financial Services Group, 65 percent of grandparents surveyed reported that they plan to contribute financially to their grandchildren’s college education, but that less than one third of all survey participants talked with their adult children about those plans.

Statistics show the amount of money that changes hands between grandparents and their grandchildren is substantial even before the kids head off to college. Hartford reports that more than 40 percent of grandparents spend more than $2,000 annually on their grandchildren before they reach 18 years old. And once it’s time for the kids to head off to school, over half of grandparents who plan to contribute will give more than $10,000, with a quarter of those planning to give more than $30,000.

A visit to a CERTIFIED FINANCIAL PLANNER™ professional can help grandparents and their adult children coordinate a gifting strategy that makes sense. In the meantime, there are several options to consider:

Talk: Adult children and their parents might find it difficult to talk about money issues in general, but discussing a positive goal like funding a child’s future can pave the way to make discussions later about the grandparents’ estate issues and end-of-life care a little easier to handle. But initially, these discussions will hopefully deliver a reality check. The Hartford survey points out that 60 percent of the grandparents surveyed believe that financial aid will be the most likely way their grandchildren will pay for college in an era where federal aid is declining and grants and scholarship cover only an estimated 15 percent of total college costs.

Start early: While many families don’t turn to relatives for help until there’s an immediate need, earlier planning almost always produces better results. Grandparents already know that saving for a child’s college education is easier if it starts at birth. The same is true for the next generation, so grandparents or adult children need to set a plan in place as early as possible for maximum benefit.

Coordinate college support with overall estate planning: Grandparents should look at their support for their adult children and grandchildren as an overall part of their estate strategy. A CFP® professional, in concert with estate and tax experts, can help grandparents and their adult children settle a series of estate issues at one time, saving time, money and worry later.

Consider the 529 plan option: A 529 college savings plan is an investment vehicle operated by a state or educational institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Service Code, which created these plans in 1996. If parents have set up a 529 plan for their child, grandparents can contribute to that plan or they can set up their own 529 plan account with their grandchild as the beneficiary.

Watch the fees: No matter what savings or investment options you choose, make sure you’re not overpaying fees. A stock mutual fund may charge in excess of 1 percent of assets; you can certainly find quality mutual funds that charge less. Two good resources: Morningstar.com can provide you a general review of most mutual funds you might be considering. The second is the Security and Exchange Commission’s online Mutual Fund Cost Calculator () which can help you determine how the fees and other costs associated with the fund will add up over time.

Offer some investing training wheels: Grandparents have a unique relationship with their grandchildren. They can teach without “lecturing” like their parents, and for that reason, they might consider setting up an investment account with a small balance that the kids can monitor and discuss under the supervision of the grandparent.

Make the grandkids beneficiaries: Naming your grandchild as the beneficiary of a retirement account or insurance policy can be a tax-smart way to provide financial support for college or possibly a first home.

October 2009 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V Higgins, CFP, ALU, AEP, a local member of FPA.

Why is estate planning important when you have a child with special needs?

Preparing for the day when you won’t be around to care for your family is a challenge that all parents face. But as a parent of a child with special needs, your estate planning needs are especially complex. Your will, and other estate planning documents you prepare, must address your unique concerns. These concerns may include:

• Providing for adequate lifetime care or assistance
• Appointing someone to manage your adult child’s finances
• Maintaining your child’s eligibility for government benefits
• Avoiding family conflicts

An attorney and other financial professionals experienced in planning for children with special needs can help you draft a comprehensive estate plan to ensure that your child is well-provided for after your death. If you already have an estate plan in place, you should have all existing legal documents reviewed (and revised, if necessary) to make sure they address your family’s needs.

Wills

A will is the cornerstone of any estate plan. It ensures that your money and property is distributed according to your wishes upon your death, and allows you to select a guardian for your child. Without a will, probate assets will pass according to the laws of intestacy, which generally assign a portion of the assets to the surviving spouse and a portion to the children. If your disabled child requires more financial resources than other beneficiaries, it’s especially important to prepare a will that reflects your wishes.

Trusts

A trust is a legal entity that enables you to leave assets to your disabled child (and others) outside of your will. You can create a trust during your lifetime (a living trust) or in your will (a testamentary trust). As the creator of a trust, you can decide what assets will be transferred to the trust, who the beneficiaries will be, what the terms and conditions of the trust will be, and who will manage the trust. Trusts are typically used to:

• Avoid probate
• Manage assets
• Provide for minor children
• Avoid estate taxes
• Protect assets from creditors

One type of trust, called a special needs trust, can play an important role in your estate plan. Specifically designed for the benefit of disabled individuals, a special needs trust can allow you to provide for your child without jeopardizing his or her eligibility for government benefits, an advantage not offered by traditional trusts.

Why use a special needs trust?

Government benefits, such as Medicaid and Supplemental Security Income (SSI) can be vital sources of support for your disabled child, especially if he or she is unable to buy, or afford, private health insurance. But because these government programs are needs based, your child will become ineligible for benefits if his or her countable assets (e.g., cash and other liquid assets) exceed $2,000, the limit that applies in most states. An inheritance, a gift from a relative, or a personal injury award may push your child’s assets over the limit, resulting in the loss of government support.

Unfortunately, government benefits generally provide only basic support. The portion of assets your child is allowed to keep and the small allowance for personal care he or she receives under government benefit eligibility rules may not be enough to pay for necessary items and services, such as eyeglasses and dental care. It is almost certainly not enough to allow the child any “luxuries” such as vacations or gifts for others.

If you want to provide funds that can be used for expenses not covered by government benefits while preserving your child’s eligibility for those benefits, consider establishing a special needs trust. Because assets deposited into, and income generated by, a properly drafted special needs trust will not be considered “available” to your child, they won’t jeopardize his or her eligibility for Medicaid and SSI.

In addition, establishing a special needs trust is often the best way to guarantee that funds you leave are used for your child’s benefit. Although disinheriting your child or leaving money to other family members on his or her behalf may initially preserve your child’s eligibility for government benefits, your child may someday be left without adequate support if these benefits are reduced or eliminated. Another concern is that creditors may attach money left to a family member if, for instance, that family member is held liable for an auto accident or declares bankruptcy.

If you are interested in establishing a special needs trust, consult an attorney who is experienced in special needs issues (including Medicaid planning), and the laws governing special needs trusts in your state.

Letter of intent

A letter of intent is a document that describes how you want your child to be cared for after you’re gone. Although it’s not a legal document, it can provide important information to guardians, trustees, family members, and others involved in the care of your child. The letter may address such issues as your child’s medical needs, daily routine, interests, likes and dislikes, religious practices, living arrangements, social activities, behavior management, and degree of self-sufficiency. Such a letter can prove invaluable to your child’s caregivers after you’re gone, and can also make the transition to a new living situation as smooth as possible for your child.

Beneficiary designations

With certain assets (such as life insurance policies, retirement plans, and annuities) you must designate beneficiaries and/or contingent beneficiaries. You’ll also name beneficiaries under your will. Although your first inclination might be to name your child with special needs outright as your beneficiary, such a designation could jeopardize his or her entitlement to government benefits. Instead, consider establishing a special needs trust for your child and designating the trust as your beneficiary.

Guardianship issues

Although you are the natural guardian of your disabled child during your lifetime, who will care for your child after your death? Selecting a guardian who can act on your child’s behalf after you die is one of the most important decisions you face. The person you choose must be able to handle the complex financial, legal, and personal needs your child may have.

Depending on the extent of your child’s disability, you may also need to choose a person who is committed to serving as guardian even after your child reaches adulthood. The law doesn’t assume that a special needs adult is incapable of handling his or her affairs. After reaching the age of majority (generally age 18), your child is a legal adult. He or she will be judged capable of handling his or her own affairs unless declared incapable by a court. If such a determination is necessary, the guardian you choose now may need to serve as guardian throughout your child’s life.

Guardian defined

A guardian is someone with the legal power to care for another person and manage that person’s personal and/or financial affairs. A guardian can advise your child, manage assets, and oversee your child’s care after your death. Generally, you’ll nominate a guardian, along with several contingent guardians, in your will. The court has final approval, but it will usually approve whomever you nominate, unless there are compelling reasons not to do so.

Types of guardians

There are two basic types of guardians: a guardian of the person, and a guardian of the estate. A guardian of the person is someone authorized by a court to make only personal and medical decisions about your child. Any medical procedure performed on a child requires consent from the parent or guardian. A guardian of the person is empowered to give such consent for medical procedures and also decide where your child will live. Usually, the court clearly specifies the scope of the guardian’s power. (The guardian will also have to report to the court on a regular basis.)

• A guardian of the estate (also called a conservator) protects and manages your child’s money and other assets. The guardian has the following legal duties:
• To take possession of real and personal property and manage it for the benefit of his or her charge
• To spend the estate for the necessary care and support of his or her charge
• To productively invest estate assets

You can nominate different people as guardian of the person and guardian of the estate, or you can nominate one person to handle both functions.

Caution: Each state has its own laws regarding guardianship. Consult an estate planning attorney before choosing a guardian.

Full guardianship

A full guardianship is also called a plenary guardianship. In this case, the guardian has control over both the personal issues and the estate of your child. This is the most common type of guardianship. Typically, you will choose a full guardianship if your child’s problems are so severe that he or she cannot make any informed decisions at all.

Limited guardianship

In a limited guardianship, the guardian has authority over his or her ward only in specifically defined matters. Otherwise, the special needs child retains some control over his or her own life. The court has to pay careful attention to this type of arrangement to be sure it remains appropriate for the child.

Caution: One problem with limited guardianships is that your child may encounter a legal situation you haven’t considered. You have to anticipate the future when you set up a limited guardianship.

Temporary guardianship

If the court appoints a temporary guardian, it specifies the limited problem or limited time of the guardian’s power. Usually a temporary guardian is appointed only in a situation caused by drugs or momentary illness or in a special medical case.

What to consider when choosing a guardian

You may want to select a relative, friend, or trusted legal professional as the guardian for your child. Here are some points to consider as you make your decision:

• Does the potential guardian live close to your child?
• Does he or she have enough time to devote to your child?
• Does he or she have the interpersonal skills necessary to be an effective advocate for your child?
• Is he or she willing to take on the responsibility?
• Do you trust him or her to keep your child’s best interests in mind?
• Does he or she already have a relationship with your child?
• Is he or she willing to keep up with new programs and opportunities for your child?
• Will he or she adapt to your child’s changing circumstances?
• Does he or she have the financial ability to manage your child’s estate?

Caution: Make sure to periodically review your choice of guardian. Your child’s needs may change, or the person you initially chose may become unable or unwilling to serve as guardian.

What if you die before nominating a guardian for your child?

If you fail to nominate a guardian in your will, or otherwise die before making arrangements for a caregiver, the court may appoint a guardian for your child. If a relative does not wish to serve or does not qualify, the court may appoint a professional guardian who is a stranger to your family. The guardianship process can be expensive, time consuming, emotionally draining, and open to public view. In some cases, though, there are advantages to having a guardian with professional expertise.

Public guardian

If a child with special needs has no individual guardian, the court will appoint a public guardian for the child. Usually, this guardian has many other clients as well so he or she may not have time to watch your child’s affairs as closely as you wish. A public guardian is paid out of public funds, but since the guardian also often negotiates with public agencies, he or she may experience a conflict of interest. Public or nonprofit agencies may also be public guardians.

Caution: A public guardian is usually considered a guardian of last resort.

Corporate guardian

A corporate guardian is part of a company that sells guardianship services. A professional staff or a volunteer manages your child’s care. Usually this type of guardianship is funded by advance payment from parents, life insurance policies, or bequests. The United Way and other charities also support corporate guardians.

What if your child does not need a guardian?

Even if your child does not need a guardian (if, for instance, he or she is already a legally competent adult), he or she may continue to need care, advice, and support throughout adulthood. You may want to ask a family member, friend, or other individual to act as a caregiver or mentor for your child. Make sure, though, that the caregiver you’ve chosen has the power to act on behalf of your child should he or she become incapacitated. This can be accomplished by having your child execute certain legal documents, including a durable power of attorney and advanced medical directives. For more information see Planning for Incapacity.

The purpose of life insurance is to provide a sum of money (the death benefit) at the death of the insured. When you use life insurance as part of your college-funding plan, you can provide funding for your child’s college education in two ways. The first and perhaps obvious use is the death benefit, which can be used to pay for your child’s college education should you die prematurely. Statistically speaking, you probably will be alive to see your child through college, in which case you can still use life insurance as part of your education-funding plan. When you choose a cash value life insurance policy, you have a second way of reaching your college-funding goal. When you pay premiums on a cash value policy, some of your money is applied towards the policy cash value, making it sort of a savings account within the life insurance policy. Cash values accumulate and can be used during your lifetime via withdrawals and/or policy loans. This discussion assumes that you will live beyond the time your child enters college, and it will focus on the potential benefits of using cash value life insurance in your plan for funding your child’s college tuition.

When can it be used?

You have a need for insurance

Life insurance can be an important tool in your savings plan for your child’s college education. However, it is not appropriate that you buy life insurance solely for funding college tuition. You should only consider life insurance for this purpose when you also have a need for life insurance protection. Need is determined by several factors. If you work and produce an income that your family depends on, there is likely an insurance need. Even if you don’t work outside the home but are responsible for the care of your children, there may be an insurance need. The worksheet How Much Insurance Do You Need? will give you a guideline to help you and your financial planner determine appropriate levels of life insurance coverage.

Tip: If you already have insurance, review your existing coverage every few years. Changes in your life (such as salary increases, marriage or divorce, the birth or adoption of a child, or purchase of a residence) may indicate a need for a change in coverage.

You have a long time before tuition funds are needed

Insurance companies often charge the policy expenses such as fees and commissions in the earlier years of the policy. Because of this expense front-loading, several years could pass before your policy cash values begin to accumulate to sizable amounts. It is generally recommended that cash value insurance be considered for purchase when you intend to hold it for a long period of time, usually at least 10 or 15 years.

Tip: Check your existing policies. If you already have life insurance with cash values (remember that policy you bought 10 years ago?), you may have a head start on your funding plan for your child’s college education.

Strengths

Your family is provided with life insurance protection

Unlike other investments or a savings account, life insurance provides your family with a death benefit (i.e., a sum of cash paid after your death). Generally, the amount of the death benefit is significantly larger than the total premiums paid for the policy. If you should die before your child enters college, tuition can be paid from the policy death benefit. Should you live (which is much more likely), you can use policy cash values to pay for some or all of your child’s tuition. Your family still receives the benefit of life insurance as long as the policy remains in force.

Policy cash values grow tax deferred

The portion of your premium payment that is applied to cash value is invested either by the insurance company or at your direction, depending on the type of policy. Positive investment returns increase the cash value. You are not subject to taxes on the growth in cash value until you withdraw the cash values or cancel (surrender) the policy. It is possible that you may be able to withdraw cash values and not be subject to income tax on the withdrawal. For more information, see the section on tax implications.

Diverse investment choices are available for cash values

The cash values in your life insurance policy are invested in investment vehicles that traditionally have the potential to earn higher returns than an ordinary savings account at a bank. The investment options (normally called subaccounts) usually include bonds or stocks. You can buy a life insurance policy that lets you select the specific investments, or you can leave the investment choices up to the professional investment managers with the insurance company. In either case, you have the potential for higher returns (but also greater potential for loss) than if you made deposits to a traditional passbook savings account.

Tip: Read the fine print concerning the underlying investments for the insurance policy you are interested in. Shop around until you find a policy with cash value investments you are comfortable with.

Caution: Variable life and variable universal life insurance policies are offered by prospectus, which you can obtain from your financial professional or the insurance company. The prospectus contains detailed information about investment objectives, risks, charges, and expenses. You should read the prospectus and consider this information carefully before purchasing a variable life or variable universal life insurance policy.

Cash values can be withdrawn

When the time to pay college tuition arrives (or you need the money for any other purpose), you might withdraw some or all of the cash value from your policy, much like a withdrawal from a bank account. The amount you can withdraw is generally limited to a percentage of the cash value and varies by policy and company. You may be able to withdraw from your cash values and still keep your insurance in effect to provide a death benefit at your death.

Tip: It’s a good idea to leave enough cash value in the policy to maintain the policy and cover the policy fees.

Caution: Cash value withdrawals may reduce the death benefit.

Cash values can be borrowed against

Cash values can be borrowed against using a policy loan. Policy loans are allowed under the terms of your insurance contract and are not affected by your current financial position. In other words, you don’t have to undergo a credit check or a bank loan approval process for a policy loan. When you take a policy loan, the check you receive comes out of the general funds of the insurance company, not your cash value. Your policy cash value serves as the loan collateral. The interest rate for a policy loan is known in advance and may be lower than that on a bank loan.

Tip: Some policies allow borrowings at an interest rate only slightly higher than the rate being credited to cash values. With some policies, the loan interest rate charged equals the rate credited to cash values, for a zero net cost loan.

Caution: If either your dividends or the increases in cash value are reduced, this is also part of your cost to borrow.

Caution: If you die with an outstanding policy loan against your account, your death benefit is reduced by the amount of the outstanding loan balance.

Caution: Interest accrues on the unpaid loan balance. If you choose not to repay the loan, the accruing interest could erode your cash values and result in a policy lapse with some types of policy.

You can combine withdrawals with policy loans

Cash value withdrawals and policy loans are not exclusive events. You can use a combination of withdrawals and loans to maximize the tax-free cash withdrawal benefits. You might choose to make cash value withdrawals up to the amount of your policy basis and then take a policy loan. In insurance terms, this is referred to as “surrender to basis and switch to loan.”

Example(s): Let’s say you have a son you are putting through college. You own a cash value policy that you bought just after he was born, and you are considering accessing your cash values to pay this year’s tuition. The first thing you might do is to make a tax-free withdrawal of cash value from the policy equivalent to the amount of premiums you have paid into the policy. After you withdraw to your basis, you take a policy loan.

Insurance policy can be gifted to your child

As the owner of a life insurance policy, you may be able to transfer ownership to someone else by gift. As part of your overall financial and estate planning, you may choose to gift the policy to your child. To attain the maximum allowable tax benefit from your policy, you may want to withdraw cash value equivalent to your basis in the policy before you make the gift.

Example(s): Let’s say you have a daughter you are putting through college. You own a cash value policy that you bought when she was very young. She doesn’t have an income because her “job” at present is that of an unpaid archaeologist working on a project in France. You are considering making a gift of your cash value insurance policy to your daughter. Before you make the gift, you may be able to make a tax-free withdrawal of cash value from the policy equivalent to the amount of premiums you have paid into the policy. In insurance terms, this is referred to as a withdrawal to basis. After you complete the withdrawal to basis, you gift the policy to your daughter. As the new owner, she can now withdraw from the cash value. Her withdrawals will be taxed at her income tax rate, which presently is considerably lower than your rate. Another option is for her to take a policy loan against the remaining cash value.

Caution: Depending on the amount of the cash value gifted, part of it may be considered a taxable gift. Also, you may need to continue the gift with additional gifts of the premiums in order to keep the policy in force. Otherwise, your low-income college student may not be able to make the premium payments, and the policy could lapse.

Life insurance values are not included in federal methodology for financial aid

Under the federal financial aid formula, assets are grouped into two categories: assessable and nonassessable. Life insurance policies fall into the nonassessable category. In other words, the value of your cash value life insurance is not counted as income or assets in the financial need calculation. The amount of federal financial aid your child is eligible for is not reduced because you have life insurance containing cash value.

Although life insurance values are not included in the federal methodology, many colleges and universities do look at these values when assessing financial need and assistance at the school level.

Tradeoffs

You must be insurable

In order to get life insurance, you must be considered insurable by an insurance company. Insurability can be affected by such factors as medical history, age, or participation in dangerous hobbies such as auto racing. Life insurance is not available to people in extremely poor health, although few people are actually refused insurance.

Tip: Even if you have a history of health problems, you may still be able to buy a rated policy. The premiums are higher than for a preferred policy (whose favorable premiums reflect the fact that the applicant is less likely to die than a standard applicant), but your need for insurance protection may make it worth the expense.

Premiums represent financial obligation

Once you buy a life insurance policy, there is often an ongoing expense: the premiums. In the early years of the policy, the premiums represent a contractual obligation. Obviously, when you pay premiums, you have less cash available for other purposes.

Tip: In the later years of the policy, you may be able to reduce the amount of premiums you pay. This depends on the type of policy, so check out the details of your policy. With some policies, you can reduce your death benefit when your need for insurance is reduced (e.g., when your child has completed college). The death benefit reduction would be accompanied by a reduction in your premiums. Check the policy for details.

Amount of insurance must be justifiable

When you buy life insurance, you purchase a policy with a stated death benefit, also called the face amount. An appropriate death benefit is calculated beginning with your current income and your economic life (i.e., what you can be expected to earn during your working lifetime). There are several ways to calculate a life insurance need, but in the end, the death benefit must be justifiable in order to satisfy the insurance company’s financial underwriting process.  As a result of this death benefit limitation, your cash value potential is also limited. For instance, a 30-year-old person with an income of $30,000 would not be eligible to buy the same amount of insurance as a 50-year-old person with an income of $1 million.

Your cash value contributions may be limited

Because life insurance contracts receive favorable income tax treatment, the government has restricted the amount of money that can be paid into policies that are treated as life insurance contracts for tax purposes. There are specific rules that define a life insurance contract for tax purposes. These rules limit the amount of cash you can put into a policy that is treated as a life insurance contract.

There may be a death benefit restriction

If the cash value in a policy is too high relative to the policy death benefit, cash value increases will be taxed instead of being allowed to grow tax deferred. The excess cash value must be distributed to you. The cash value might become too high relative to the death benefit if the underlying investment experiences high returns or if the death benefit is reduced. In addition, the size of the policy you are eligible to buy is limited by your age and income under the financial underwriting requirement that the amount of insurance be justifiable.

You may be subject to modified endowment contract (MEC) rules

The modified endowment contract (MEC) rules were established to prevent people from using life insurance policies as tax-free investments for large sums of money. The MEC rules limit the amounts you can pay into a policy during the first seven years of the policy’s life. If you exceed the limits, the policy is permanently classified as a MEC and is subject to special tax rules. Under these rules, policy loans are generally taxable, and withdrawals are not only taxable but may also be subject to a 10 percent penalty tax.

Underlying investments subject to fees, potential losses

The underlying investments in a cash value policy may be subject to losses, depending on the performance of the investment and the markets. Just as investment gains are added to your cash value, losses may be deducted, depending on the specific policy. Investments are also subject to management and administrative fees.

Tip: Read your contract and prospectus concerning the underlying investments and any associated fees before you choose a policy.

What factors should you consider when choosing a policy?

When planning for college expenses, parents are often concerned with four areas: tax benefits, financial aid, control issues, and investment costs. Generally, all types of cash value life insurance will provide you with the same benefits in the areas of tax benefits and financial aid. The major difference between various policy types occurs in the areas of control and costs. The following types of life insurance all contain cash value and may be used for funding your child’s college education.

• Whole life
• Variable life
• Universal life
• Variable universal life

Tax benefits

The following tax characteristics are common to all types of cash value life insurance.

• Cash value grows tax deferred
• Cash value withdrawals to basis are not taxable
• Policy loan proceeds are not subject to income tax
• Death benefit is generally received by beneficiary free from income tax

Financial aid

Some assets, like cash value life insurance, may be treated differently depending on who is doing the financial analysis, the government or a college.

• Federal financial aid methodology doesn’t include policy cash values in parents’ total assets when determining a child’s financial need
• Individual colleges may consider policy cash values when determining a child’s financial need

Control issues

In all cases, when you own a cash value life insurance policy, you control the policy. You can decide if withdrawals are to be taken when allowed under your policy or if you want to take a policy loan. You choose the policy beneficiary who will receive the death benefit when you die. However, between the various types of cash value policies, there are differing levels of control over the cash value investments and premium payments. These may be key factors in choosing the appropriate life insurance type for saving for your child’s college education while also protecting your family’s income at your death.

Control over cash values

You have two options concerning your policy cash values. You can choose from investments offered by the policy, assume the investment risk, and monitor the performance of your cash values, or you can leave that to the insurance company’s fund manager.

Control over premium payments

All life insurance policies require some payment of premium. However, depending on the policy you choose, you may be able to control the timing and amount of your premium payments. You might want to pay a fixed amount that is due on a specified date that you can budget for indefinitely. On the other hand, you may want the flexibility to decide if you will occasionally pay a larger or smaller premium or skip a payment altogether. You may want to pay your premium in an up-front lump sum, thereby eliminating future payments.

Investment costs: Premiums

When you buy life insurance, you incur a direct cost–the premiums you pay for the policy. Premiums generally include the cost of the insurance protection as well as certain administrative expenses, risk charges, and processing costs. With universal life and variable universal life policies, the expenses are itemized in the policy prospectus. With whole life and variable life, the expenses and charges may be bundled (i.e., you can’t easily determine and compare charges for individual items).

Tip: Often the expenses are front-loaded; that is, the expenses and charges are deducted directly from each premium payment, with the balance of the premium payment being credited to the cash value account.

The significance of premium differences

It may be tempting to compare different policies based solely on the premium amount. This method may not be reliable, however. Many policies receive dividends from the insurance company that are based on the company’s investment returns or expense experience. Even if a policy seems to have a high premium, if the policy also receives high dividends, its cash values accumulate rapidly. Moreover, if it receives high interest credits, it may actually be less costly than a policy with a lower stated premium.

Tip: Check with your financial planner. There are several different formulas for comparing policy costs. The policy with the lowest premium may not actually be the least expensive.

Fees, penalties, and charges

In addition to premiums, there may be other fees, penalties, and charges related to your policy. If you withdraw cash value or take a policy loan, the insurance company may charge a processing fee. If you take a cash withdrawal or a policy loan, there are costs you incur in the form of foregone interest on the amount of the withdrawal or loan, not to mention the interest that accrues on the loan amount. If you choose to cancel the policy, there may be surrender charges involved, which will vary depending on how early or late in the life of the policy the cancellation occurs. Some policies carry a 15- to 20-year surrender schedule.

Tip: If you already own life insurance, check your policy and consult your agent about fees and interest charges if you are considering a cash withdrawal or policy loan.

Tip: If you are in the process of buying a policy, compare several policies before you make your choice. Fees and processing charges can vary by company and policy type.

What are the tax implications?

Income Tax

Premium payments not deductible

Life insurance premium payments are not tax-deductible expenses.

Cash withdrawals may not be taxable

Life insurance policy cash value withdrawals are considered a nontaxable recovery of your policy basis until the entire policy basis has been withdrawn. There are special rules for policies that are classified as a modified endowment contract (MEC), which are not discussed here.

Example(s): Say you own a life insurance policy (non-MEC) with a cash value of $15,000. Your basis in the policy equals $12,500. You plan to take a withdrawal of $7,000 now to pay for part of your son’s tuition. You won’t have to pay tax on this withdrawal amount because it will be considered a return of your basis.

Caution: Withdrawals in excess of your basis are treated as taxable distributions of interest or gain.

Caution: Cash value withdrawals that occur in the first 15 years of the policy and are accompanied by a reduction in the face amount may be treated as ordinary income to the extent that the cash value of the policy exceeds the policy basis.

Policy loans generally not taxable

When you take out a loan against your life insurance policy (except a modified endowment contract (MEC), the amount you receive is not considered taxable income. This rule applies even when the loan is larger than the amount of premiums you have paid in (except in the case of a MEC).

Example(s): Say you own a life insurance policy (non-MEC) with cash value of $20,000. Your basis in the policy is $17,000. You decide to take a policy loan to pay your daughter’s tuition. Under the terms of your policy, you are allowed to take a loan for an amount up to 90 percent of the policy cash value–in this case, $18,000 ($20,000 x.90). You are not subject to tax on the amount of the loan, even though the loan is larger than your basis.

Policy loan interest not deductible

Interest you pay on a policy loan is generally not a deductible expense (under certain circumstances, interest on loans used for business or investment purposes may be deductible).

Policy cancellation may be taxable

If you cancel (surrender) your policy for cash, the gain on the policy is subject to federal income tax. The gain on a canceled policy is the difference between (1) the net cash value and any loan forgiveness amounts, and (2) your policy basis.

Caution: If you surrender your policy while there is an outstanding policy loan, there could be additional tax consequences.

Death benefits generally not subject to federal income tax

Policy death benefits are generally not subject to federal income tax.
Gift Tax

Policy proceeds not considered gift to beneficiary

When the proceeds of your life insurance policy are paid to a beneficiary other than yourself (as the owner-insured) or your estate, they are not treated as a gift for gift tax purposes.

Policy premium payments generally not subject to gift tax

When you are the owner of a policy on your own life, with another party as the beneficiary, premium payments made by you are not considered a gift to the beneficiary for gift tax purposes. If, however, someone else pays the premiums on a policy you own, the premium payments are considered a gift to you and may be subject to federal gift tax if the annual premiums exceed the annual gift tax exclusion.
Estate Tax

Policy proceeds included in estate value in some cases

The proceeds of a life insurance policy are included in the value of your estate if you held any incidents of ownership at any time during the three years before your death or if the proceeds are payable to you or your estate. Some examples of incidents of ownership include the right to change the beneficiary, to take out policy loans, or to surrender the policy for cash.

Policy proceeds often exempt from state inheritance tax

In many states, life insurance proceeds are exempt from state inheritance taxes.

April 2009 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V Higgins,CFP , a local member of FPA.

It’s a few short weeks until cap and gown season begins, and for grandparents hoping to do something nice for their grandkids and something sensible for their estate, there are several options to explore.

Roth IRAs: The Roth option is a good one if you want to help them start a retirement fund of their own or if you want them to inherit a Roth where they can make tax-free withdrawals after your death.

Roth IRAs aren’t a useful alternative for very young kids because the rules state that all Roth holders have to have earned income to be able to make contributions. If they fit that description – as many kids working in high school do – either their parents or guardians can open the account and grandparents can make contributions to match the percentage of earnings kids put in their Roth IRA. Grandparents simply match that contribution.

Also, if you have a Roth IRA, you can benefit your grandchildren by naming them as your primary beneficiaries, and when they inherit it, they’ll be able to make tax-free withdrawals for a home, an education or any other purpose.

Parents or grandparents may want to consider setting up and funding a Roth IRA for their children or grandchildren as soon as the children or grandchildren have enough earned income from part-time or summer jobs. This will ensure that the five-year requirement is met when the individual for whom the Roth IRA is established is ready to make a withdrawal to buy a home, for example.

529 Plans: Another great tool for grandparents is the 529 college savings plan. Grandparents can fill out a plan enrollment form designating a grandchild as beneficiary, select the investments from the plan’s options, and make future contributions either by check or by automatic contribution.  It’s also fine for grandparents to make their contributions directly to a 529 account already owned by the grandchild’s parents.

As a refresher, 529 college savings plans – named for the federal law that created them in 1996 – allows a parent to open a tax-deferred college savings plan with as little as $25 to start in some states.  A 529 college savings plan is not the same thing as a 529 prepaid college tuition plan. Prepaid tuition plans are just that – tax-deferred savings plans that allow you to save for tuition for in-state schools (though some plans allow you to transfer out a portion of those assets to out-of-state schools). Also, it’s important to note that prepaid tuition plans are not an automatic guarantee a student will get into that college.

Since 2006, withdrawals from 529 plans have been permanently tax-free. In some states, contributions may also be deductible on state tax returns. All 50 states now have 529 plans college savings plans, and a majority of them provides additional incentives, such as a state-tax deduction to in-state residents who invest in their respective plan.

It’s a good idea to have your financial adviser or your CERTIFIED FINANCIAL PLANNER (TM) professional help you sort through the details of various state plans. There are various services – including Morningstar Inc. – that now rank the offerings of each state’s plan.  www.SavingforCollege.com and www.FinAid.org are leading sites to help educate you in how these plans work.

Grandparents can treat their contribution as complete gifts, which means they can apply the $12,000 per year gift tax annual exclusion or an accelerated contribution of up to $60,000, with a special five-year, gift-spreading election. Check with your tax adviser first.

Another great benefit is that a 529 plan owned by grandparents should not affect the grandchild’s eligibility to receive federal financial aid because a grandparent’s assets are not reportable on the free application for federal student aid, or FAFSA, and the tax-free withdrawals from a grandparent-owned 529 plan are not counted as student income or student resources.

Coverdell Education Savings Accounts: For grandchildren heading to private school who are under the age of 18, most grandparents – check your eligibility with a tax professional first – can contribute up to 2,000 dollars annually per grandchild to a Coverdale Educational Savings Account.  Coverdell earnings accumulate free of federal income taxes, and can be taken to pay for private elementary, secondary or college. Yet, your income is a factor. You can make a Coverdell contribution as long as your modified adjusted gross income is between 95,000 and 110,000 dollars if you’re single or between 190,000 and 220,000 dollars if you’re a married and filing jointly.  Yet, if you exceed either of these requirements, you can ask the parent of the adult child to open up the account and make the contribution, though you will have to give up control over the account.

Make a direct gift of your grandchild’s tuition: Under current tax law, you can make gifts of any amount to cover your grandchild’s tuition. Yet, you’re going to need to pay the college directly and you need to be aware that it won’t dent your federal estate tax exemption (3.5 million dollars in 2009), but it will cut the overall amount of your taxable estate.  You can, however, go ahead and make additional gifts per grandchild of $13,000 to help with other college expenses.

April 2009 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V Higgins,CFP , a local member of FPA.

Even if you’ve planned relatively well for your future college student’s expenses, the credit crunch and downturn in investment income for colleges have changed the game for financial aid at many schools. That means both parents and students need to approach the college financial aid scene with unprecedented caution.

Harvard University, the world’s richest school, announced in February that it was slashing 25 percent of its investment staff after its $36.9 billion endowment lost 22 percent of its value in the previous four months and could decline as much as 30 percent by the end of June.  In two separate surveys released in January, the Commonfund Institute and TIAA-CREF, in a survey done for the National Association of College and University Business Officers, reported that college endowments fell on average 23 percent in the five months ended Nov. 30, 2008.

Why is this important? It’s true that endowments at schools of all sizes mostly pay for faculty and facilities. But they also provide both grants and scholarships for talented students who need them and have been under significantly more pressure to do so. When students have a tougher time finding lower-cost school financing, the demand for scholarship and grant funding goes sky-high. In many cases, students are forced down the borrowing chain to increasingly risky loan options.

The private student loan sector has also been hit by reports of questionable practices in the last two years. In December, New York Attorney General Andrew M. Cuomo reached an agreement with the College Board – the developer and administrator of the SAT and AP – to stop discounting products and services in exchange for a ranking on colleges’ preferred lenders list.  The College Board will now invest $675,000 to develop a set of tools to help financial aid administrators to help students and parents compare student loan offers and identify the lowest-cost loan options.

What can you do? One of the best starting points is a meeting with a CERTIFIED FINANCIAL PLANNER™ professional with specific expertise in planning for college and financial aid options.  The smartest thing is to work with a planner when kids are young to amass the right amount of savings for college, but it makes good sense for both parents and students to meet with a planner before school starts to underscore the complete list of financial issues the student will face. These include:

Planning alternatives for financial aid shortfalls: Over the past few years, colleges have not been able to offer adequate amounts of funding through Perkins, Stafford and Plus federal education loans, and private student loans through banks have closed up with the credit crunch. For students already admitted at schools for their freshman year in the fall, financial aid letters will start going out this month.
Here’s the catch – many college students get in trouble with debt because they are unaware that many for-profit companies advertising access to federal loans pull their financing from private sources that cost the borrower far more than actual federal loans would.  The ability to plan for college well in advance and work with an expert to sift through proper loan alternatives can make the difference between an affordable debt load when a student graduates and potential bankruptcy.

Setting a budget as early as possible for basic expenses: Until the student gets to school it will be tough to tell what actual expenses will be, but it won’t hurt to set a tentative budget that involves taking full account of the student’s savings, the parents’ (and possibly the grandparents’) contribution to everyday expenses and any planned income from work-study or other sources. For a template of a budget written specifically for college students, go to: http://www.aie.org/Calculators/budgetworksheetinschool.cfm

Start managing credit and debit cards before school starts: The time to start managing credit and bank accounts isn’t freshman year. While a teenager won’t build a credit history as an authorized user on a parent’s card, it’s good to get a little practice using it under a parent’s watchful eye. When a child goes on to college, the challenge will be looking for the best credit card offer amongst many and managing that credit responsibly. This is another good reason for both parent and student to meet with a financial planner ahead of school to discuss proper credit card usage and monitoring of a student’s fledgling credit score.

March 2009 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V Higgins,CFP , a local member of FPA.

The average college graduate is $20,000 in debt, and today’s young adults are clearly exposed to more opportunities for self-directed financial disaster than any group in history.

Despite the current credit crunch, credit cards are still a common way most young people afford their new adult lifestyle, and rising costs on everything from rent to gasoline presents deeper challenges.

So it happens. Your kid gets in trouble with those credit cards, loses a job, or can’t find a job to pay the sum total of the rising debt he or she has. What can you do?

Make sure you can afford to help: It’s tough to say no to a financial bailout for your kid, but depending on the level of trouble he or she is in and your own financial responsibilities, you may need to.  Here are some ideas:

Both sides should come clean: Remember that this situation is as much about the relationship as about money. The decision to help a family member with money problems requires understanding – lecturing tends to work not so well. But it’s right to encourage your kid to take a frank look at their financial situation and if they are in debt trouble of any kind, they should get help. It’s also important that you show confidence that they will make it through this.

Consider a joint talk with a financial planner: A financial planner, such as a CERTIFIED FINANCIAL PLANNER™ professional, can look at their financial situation and your own and give you both a road map on how to work through your child’s money problems and set up better money management techniques for after the crisis.

Should help be considered a gift? Actually, this is a good first question in any scenario where you offer help to a friend or family member. What happens if you don’t get the money back? For the sake of the relationship involved, it might make sense to think through that possibility. Would the potential loss of money injure you, and worse, will it injure the relationship? This is why it might be a very good idea to present this solution as a one-time gift – and then stick to it.

But if it’s a loan: You need to structure it professionally with clear consequences if it goes unpaid. Handled correctly, such a solution can offer benefits for the borrower and lender alike. Terms should be at arm’s length to meet IRS rules but it can still be more attractive than the child could obtain in the current marketplace. But there’s the potential for incredible downside. Unclear agreements can lead to missed payments or default. If the borrower dies suddenly, the lender’s investment may be lost if the agreement isn’t structured correctly. A properly executed promissory note is still an obligation of the estate, and may continue to be paid to an heir or other person or entity based on the terms as agreed.  It is advisable that the loan agreement be in writing and properly executed to meet IRS rules.

Work with them on budgeting: It’s not going to be enough to solve the immediate problem. Even if you don’t use a financial planner to help you both work through the situation, it’s important to set a clear financial course for your child going forward. They obviously have to have a stake in the planning, but you’re going to have to provide guidance.

Encourage them to start an emergency fund: Even if your child only has a few cents in their pocket after settling their troubles, encourage them to start an emergency fund. Optimally, they’ll need to stash away three to six months’ worth of living expenses, and even if it’s just a small start, it’s part of the recovery effort.

You can help your children financially in many ways, even after they are well into their adult years—and most of those ways don’t involve giving them money.

Here are a handful of tips from CERTIFIED FINANCIAL PLANNERTM practitioners about how to make your children’s financial lives a little easier, often in ways you might not expect.

Teach them good money management skills and money values. Sure, you can donate cash to their savings account, EE bonds in their name, or shares of stock or mutual funds. But the gift that really keeps on giving their entire lifetime is a sound financial education backed by the demonstration of your sound money values.

If you’re unsure of how well you can do this yourself, have them work with your CFP® financial planner. Also give them money management material designed for children of different ages and have them take classes geared toward their ages. They need to learn such financial skills as budgeting, investing, retirement planning, insurance, taxes, charitable giving, how to read a pay stub and balance a checkbook, and what role money should play in their lives.

They may never thank you for this gift, but these skills and values will likely earn them far more money, and make better use of that money, than all the monetary gifts you ever make to them.

Set a good example. You can teach them the best money management skills in the world, but if you don’t exemplify good money management judgment yourself, they probably won’t either.

Open an IRA. Okay, okay, this involves giving them cold cash. But think of it as seed money, pump-priming money, a chance to reinforce the message that they will likely have to fund most or all of their retirement, as employer pensions is disappearing and Social Security may only provide minimal help.

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When they first start earning taxable income from outside jobs or even from household chores such as mowing the lawn, have them open an individual retirement account. Most experts recommend a Roth IRA, which is funded with after-tax money, because the tax-savings benefits of a traditional IRA are minimal for children earning little income. With the Roth, they can later withdraw the contributions and the earnings tax free.

Explain why they need an IRA (for that retirement they’ve got to fund, remember). Then match dollar for dollar whatever amount they can realistically invest in it (your combined contributions can’t exceed their earned income for the year or the 2005 maximum of $4,000, whichever is smaller).

Take care of your own retirement. Fund your retirement even if it means your children have to pay their own way through college. They can get loans or go to a less expensive school. There’s no financial aid for retirement if you fail to save enough, and you want to avoid asking them for handouts in your old age.

Don’t be a financial burden on them. This means not only making sure your retirement is properly funded, but that you can pay for medical care and possibly long-term care—two huge expenses during retirement many people overlook. Review your medical coverage, including possible retiree health benefits, Medigap insurance once you start Medicare, and long-term care insurance. Spare your children the financial burden of having to financially assist you at a time they’re probably trying to save for their own retirement and put your grandchildren through college.

Have an estate plan in place. Basics include a will, a financial power of attorney, a living will, and a health care power of attorney (also known as a health care proxy). You may or may not need additional planning, such as trusts or a family limited partnership, but those four basic documents will go a long way in giving your children flexibility and guidance should you become incapacitated (when powers of attorney become invaluable) or when you die. An updated estate plan also will ensure that your children inherit what you wish them to inherit.

Keep your financial records in order. Give your children a general idea of the value of your estate and your plans for it, and let them know where they can find financial documents upon your incapacity or death. This is sensitive stuff, but it beats leaving them with a financial mess at a stressful, emotional time.

The big idea of giving PCs to poor children has been challenged by educators and business. Here, follow the misadventures of One Laptop per Child.

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