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What Is an Overfunded Life Insurance Policy?
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.
What Is an Overfunded Life Insurance Policy?
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.
The Benefits of an Overfunded Policy
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:
- Earn more interest. The main benefit of overfunding a policy is to earn interest faster. The more money in your cash value account, the more interest your insurer will pay. That’s a matter of simple math. For example, if your whole life policy pays 3% interest and you have $10,000 of cash value, you will earn $300 in interest each crediting period. But if you overfunded the policy and socked away a total of $30,000 in your cash value, you would earn $900. That’s three times the cash value – imagine that compounding over years or even decades.
- Tax-deferred growth. Cash value grows tax-deferred. That means no income tax is due until you withdraw more than the amount you’ve paid into the policy. What does this mean for you? Your cash value grows faster because you owe zero income tax as long as that cash stays put. This is the same feature that helps traditional retirement accounts like 401(k)s and IRAs grow faster over time. Keep in mind this rule only applies if your policy avoids being classified as a MEC (see below – we’ll explain what this is and how to avoid it, since it ruins your tax benefits).
- Policy loans. You can access your cash value multiple ways. One way is through a policy loan, which is a private loan between you and the insurer. It will never hit your credit report, in other words. All you do is request the loan, and your insurer will give you the money (keep in mind there will also be a loan origination fee). Although you will be charged interest on the loan, your cash value remains in place and will continue earning interest. Depending on the prevailing rates, your earned interest will offset or perhaps entirely compensate you for the interest you owe on your policy loan. Policy loans don’t technically have to be repaid, either; if you owe on a policy loan when you pass away, the insurer will pay themselves back out of the death benefit before it’s passed to your beneficiary(ies). For clients whose loved ones don’t need the death benefit, this isn’t a problem or a drawback at all.
- Partial withdrawals. You can also access cash value through a partial withdrawal. Unlike a loan, this doesn’t have to be paid back. However, you’re reducing the amount of cash value left, which means you’ll accrue interest more slowly. There are also withdrawal fees, so make sure you compare this to the cost of a policy loan before choosing how to access your cash value.
The Trick: Avoid MEC Status
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:
- Non-MEC: You can access your cash value via a withdrawal or policy loan up to the amount you’ve paid into the policy with zero income tax obligation. If you pull out more than you’ve put in, you only owe income tax on the overage. While in your account, the money continues to grow tax-deferred.
- MEC: Any cash value you pull out via a withdrawal or policy loan would be subject to income tax, no matter how much you’ve paid into the policy. While still in your account, however, the money continues to grow tax-deferred.
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.
Conclusion
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 info@lifequote.com and let’s talk about how to get you set up for financial success with a new life insurance policy!
Disclaimer
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.
