Can Overfunded Life Insurance Pay Off?

In this article...
  • One way investors may increase their wealth is by overfunding a permanent life insurance policy. Learn the benefits and downside of overfunded life insurance.

Some investors may attempt to safeguard or grow their wealth by overfunding a permanent life insurance policy. However, this strategy might not make sense for everyone. In this article, you’ll learn what it means to overfund a life insurance policy and how overfunded life insurance can work as an investment strategy for policyholders, depending on their individual circumstances.

What Is Overfunded Life Insurance?

Overfunded life insurance, or OLI, is essentially a permanent life insurance policy, such as a whole or universal life plan, in which a policyholder has paid higher premiums than what is necessary to maintain the death benefit. Because this excess money isn’t needed to fund the death benefit or cover administrative costs, it immediately adds to the cash value of the policy.

Overfunded life insurance may be used as an investment strategy by policyholders who want to hasten the cash accumulation in their plan. Although it isn’t the right investment for every policyholder, it may make sense if you’re attempting to manage taxes or if you plan to access the cash for your retirement or other later-in-life expenses.

The Benefits of Overfunded Life Insurance

In addition to traditional life insurance benefits, such as guaranteed financial support for your loved ones after you die, overfunded life insurance may have several advantages for policyholders:

  • Tax-free account growth and death benefits. Because the cash value of a permanent life insurance policy generally isn’t taxable, funds can accrue more quickly. Plus, when you die, your life insurance benefits transfer tax-free to your beneficiaries.
  • Investment flexibility. Depending on the type of life insurance policy you purchase, you may have several available investment options. Variable universal life policies often let you invest your money in stocks and securities while indexed universal life policies let you place your money in subaccounts, which mirror the performance of the S&P 500 or other stock market indices. Some life insurance policies may also offer conservative, fixed-interest options.
  • Protection from losses due to market volatility. If you overfund an indexed universal life plan, your money isn’t directly invested in the stock market, so you won’t have to worry about market downsides. These plans generally set the floor of subaccounts at 0% or more, so you’ll never get back less than you invest, even if the market declines.
  • No yearly caps. When you’re overfunding a life insurance policy, you won’t have to worry about the government placing an annual cap on your contributions. On many plans, you may contribute as much as you want each year up to a predetermined overall limit.
  • When you have an overfunded life insurance policy, you may withdraw funds at any age without incurring a government penalty. Many policies also let you take out low-interest life insurance loans, which let you borrow against your policy's cash value with no credit checks or other qualifiers.

The Potential Downsides of Overfunded Life Insurance

OLI plans may also have drawbacks, and they aren’t an ideal investment option for everyone. The potential downsides of overfunded life insurance plans include:

  • Higher upfront fees. Typically, only permanent life insurance policies may be used in an overfunded life insurance strategy, and these often come with higher initial fees than term policies.
  • Surrender fees. Some overfunded life insurance policies incur surrender fees if you withdraw money before the policy reaches a certain age.

Overfunded life insurance plans may also come with a risk of policy lapse when used as collateral for a loan. If your policy lapses, your beneficiaries are left without a death benefit when you die. You may also incur taxes on any money you’ve borrowed against the plan.

Should You Overfund a Life Insurance Policy?

Whether you should overfund a life insurance policy may depend on your unique financial situation. However, there are certain people for whom overfunding a life insurance policy may make sense.

  • Individuals of high net worth. Policyholders who’ve maxed out their 401k contributions may want to overfund a life insurance policy as an alternative retirement savings plan. These funds aren’t subjected to annual contribution limits, so these individuals can set aside more of their money.
  • Individuals who’ve started retirement savings later in life. OLI plans may be ideal for individuals who delayed retirement planning and now need to set aside as much money as possible.
  • Policyholders who want early access to funds. If you plan to withdraw funds for retirement or other expenses, overfunding may make sense because it increases the amount of money available from your policy.
  • Policyholders looking for tax benefits. Because overfunded life insurance can offer account growth without necessitating income taxes on the interest, this strategy can work for investors looking for tax benefits.

Some policies don’t permit overfunding, so be sure to check with an account representative or a qualified financial professional before engaging in this type of strategy. A financial advisor can also help you determine if overfunded life insurance is a smart investment for your particular situation.

What Happens to Unused Life Insurance Money?

What happens to unused life insurance money may depend on your policy. Often, if you die, the insurance company pays the agreed-upon death benefit to your beneficiaries and then absorbs the policy’s current cash value.

To avoid forfeiting the cash value of your policy when you die, discuss options with a plan representative. Depending on the terms of your policy, these funds may be used to cover premium payments, increase the death benefit or serve as collateral for a personal loan. In some cases, policyholders may be able to purchase a rider that lets the beneficiary receive both the death benefit and the cash value of the policy upon the death of the insured.

Which Type of Policy Is Considered to Be Overfunded by the IRS?

Although the IRS doesn’t set annual caps on funding for life insurance policies, there are still federal limits to overall contributions to the cash value of a plan. If the funding of a life insurance policy exceeds limits set by federal tax laws, it’s known as a modified endowment contract, or MEC.  

Because an MEC is no longer recognized by the IRS as a life insurance contract, there may be serious tax consequences for the policyholder. To avoid incurring tax liabilities due to overfunding, consult a plan representative or financial advisor prior to engaging in an overfunding strategy.

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