What is an overfunded life insurance policy? It’s when you pay more into your policy than the minimum payments required to keep it active. If you’re not sure why anyone would do this – or how it can benefit you – we’ll explain why many high-net-worth clients use this option as a way to create wealth.
First things first: the only type of policy you can overfund is a cash value (permanent) policy. Term life policies do not accrue cash value and do not have the built-in savings component that allows you to pay more than your minimum required payments.
There are multiple types of cash value policies, but the most commonly used policy type to overfund is whole life. Why? Because of the way whole life’s cash value earns interest – at a set, guaranteed percentage that’s locked in when you buy the policy.
No matter what happens to interest rates during the length of time you own that policy, you will always earn the guaranteed rate of interest on your cash value.
When you buy your policy, your agent will give you an illustration that shows the guaranteed rate of growth for your cash value based on the exact interest rate you’re offered at the time. That illustration will only take into account the growth possible when you pay the minimum required amount every month – which is exactly what most people do.
But because of that guaranteed rate, which is often higher than what you can get from a bank or CD, many clients sock away extra money in their whole life accounts specifically to earn more interest and grow cash value even faster. That way, they can take full advantage of the many benefits an overfunded policy can provide.Get a Free Quote Now
When clients ask us, “what is an overfunded life insurance policy,” what they really want to know is why anyone would pay more than they have to into their policy. Using this strategy can generate positive cashflow that can then be used to create a supplemental income stream. Here’s how:
As with all things that sound too good to be true, you’re probably wondering: what’s the catch? And there is one – so if you Googled “what is an overfunded life insurance policy” hoping to find a get-rich-quick scheme, this isn’t it.
Because of the tax benefits of overfunding your policy, the IRS put rules in place governing how and when you can overfund and still reap all those benefits.
IRS rule 7702 is designed to keep you from overfunding your account for the first seven years you own the policy. During that time, if you overfund your account with more than your required payments, your policy could be reclassified as a modified endowment contract (MEC). Once your policy is reclassified, the tax benefits for cash value are greatly diminished:
Your best strategy? Wait out the first seven years, during which the IRS rule 7702 applies. After that point, you can contribute as much as you want to overfund your policy without the worry that it could be reclassified.
If you want to use whole life insurance to grow wealth, for example, it’s key to be sure your policy is not structured as a MEC from the get-go, and to avoid doing anything that could trigger that reclassification.Get a Free Quote Now
What is an overfunded life insurance policy? It’s a financial strategy that allows you to sock away extra cash and earn more interest than you would in a low-return vehicle like a savings account or CD. It has the added benefit of increasing your overall cash value available, which you can access via policy loans. Taking policy loans is sometimes described as “being your own banker,” allowing you to access that cash for retirement living expenses, healthcare, or other investments, all without going through the hassle of applying for a traditional loan.
To access these benefits, it’s important to work with a life insurance agent who can ensure your account gets set up correctly. At LifeQuote, we’ve helped clients use cash value policies for both retirement planning and estate planning. Call us at (800) 521-7873 or email us at firstname.lastname@example.org and let’s talk about how to get you set up for financial success with a new life insurance policy!Get a Free Quote Now
For informational purposes only. Always consult your accounting, legal, and tax advisors before implementing any recommendations. This material does not constitute tax, legal, or accounting advice. It cannot be used for the purpose of avoiding any IRS penalty.