Receiving social security benefits as a survivor or beneficiary might have a hidden benefit. Benefits payable to a child that are saved for college education expenses may offset out-of-pocket expenses required by the child and the appointed guardian or surviving parent. Make sure you understand all of the child's options before putting this money away.
A 529 savings plan is a state-run college savings plan. Contributions to this plan might be tax-deductible in the state where you live and are limited to an amount that is sufficient to fund future college expenses. Your survivor benefits may fund this plan, though you may not see the benefits of a tax deduction if you have no other taxable income. Money grows tax free inside of the plan. Any money used for college education expenses in income tax free. However, any interest earned inside of the account not used for college education expenses is subject to ordinary income tax and a 10 percent IRS penalty.
A Coverdell savings account functions similar to a Roth IRA. Contributions are made to the account on an after-tax basis and are limited to $2,000 per year. All money grows income tax free inside the account. Withdrawals are made on an income-tax-free basis as long as the money is used to pay for college education costs. Any investment earnings not used by the time the beneficiary turns 30 are taxed as ordinary income and subject to an IRS penalty of 10 percent. Any investment earnings not used for college education expenses are also subject to the same tax and penalty.
Your survivor benefits may purchase a life insurance policy. A cash-value life insurance policy builds a cash-surrender value. This cash value functions as a savings. Due to IRS restrictions outlined in IRS section 7702, the cash value of the policy cannot grow more than a certain percentage per year based on the face amount of insurance purchased and the insured's age. However, all money accumulated in the policy may be used for any purpose, including paying for a college education. Additionally, there is no limit to the size of the policy you may purchase and no "contribution limits" placed on the policy, since the policy is not specifically designated as a college savings plan.
Social Security benefits saved in an ordinary investment account may be used for college education expenses. You may deposit your survivor benefits into a savings account or some other type of account that earns a fixed or variable rate of return. All the interest in such accounts is subject to income tax in the year it's earned. However, you are unrestricted as to how much money you may contribute to the savings account and may use this money at any time.