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Overfunded Life Insurance: Why It Really Pays Off

Overfunded life insurance can help you quickly grow wealth, especially when utilized with whole life insurance as part of a Wealth Maximization Account™. In this article, we’ll explain what overfunded life insurance is and how it works, why overfunded life insurance is used by the wealthy (and large corporations), and how to use your own overfunded life insurance policy for tax benefits, cash flow, liquidity, asset protection, and more.  

WHAT IS OVERFUNDED LIFE INSURANCE?

Often when shopping for life insurance, it becomes all about finding the cheapest quote. Getting the most coverage for the least amount of money seems like the best deal, right? Well, not necessarily. Depending on your financial goals and the type of life insurance you buy, sometimes it makes sense to pay more. 

Term life insurance provides coverage for a predetermined time period, or term, and 100% of the cost of your policy goes toward its death benefit and administrative fees. If you pass away within the term, your policy pays out to your beneficiary. If you outlive your term, there is no payout and any money paid in premiums belongs to your insurance company. This is the cheapest type of life insurance and it comes with no living benefits—its sole purpose is to fund a death benefit.

Permanent life insurance policies are more expensive, but they come with several living benefits. These types of policies provide coverage for the lifetime of the insured. A portion of the cost of your policy goes toward its death benefit and administrative fees. The remainder goes into a built-in savings account called cash value. When you pass away, regardless of when that may be, your policy pays out to your beneficiary. But before that day comes, you can utilize the cash value of your permanent life insurance policy for personal loans, business capital, retirement income, or anything else you choose. On top of that, permanent life insurance policies grow your wealth by earning interest and some earn potential dividends. 

When you take out a policy loan (borrow from your cash value), any interest or dividends you’ve earned can be borrowed tax-free. Unpaid policy loans are deducted from your death benefit (plus interest) when you pass away. Paying back your policy loans can be done on your own timetable and interest rates charged by your insurance company are typically lower than those found with banks or private lenders. In fact, using policy loans from a permanent life insurance policy essentially allows you to be your own bank

If you’re interested in private banking with life insurance, it makes sense that you would want to have as much money in your “bank” as possible. After all, the more cash value you have in your insurance policy, the greater interest and dividends you can potentially earn, and the more money you can borrow (or withdraw). This is accomplished by overfunding your life insurance—paying more into your policy and/or structuring it in such a way that it is supercharged to grow wealth faster and accumulate more wealth over your lifetime. 

WHOLE LIFE VS. UNIVERSAL LIFE

Perhaps you’ve heard that whole life insurance earns low rates of return or that it takes a very long time to grow wealth inside a policy. It’s true—typical whole life insurance policies aren’t structured for optimal returns or rapid growth. But when you properly structure your whole life policy to be overfunded, you can maximize your earning potential much faster. 

Properly structured whole life insurance offers several guarantees and options not commonly found with other types of permanent policies. Plus, whole life insurance policyholders assume less risk than with other types of insurance like indexed universal life or variable universal life. 

Here are 5 reasons why whole life insurance is ideal for overfunding: 

  1. Whole life insurance earns a guaranteed rate of return.
  2. Whole life insurance from a mutual insurance company earns potential dividends.
  3. Whole life insurance guarantees level policy premiums for life.
  4. Whole life insurance policies aren’t subject to market volatility.
  5. Whole life insurance policies can utilize a paid-up additions rider to optimize growth.

This last benefit, a paid-up additions rider, is a type of supplemental life insurance key to an overfunded life insurance policy. Its primary goal is to allow you to contribute the maximum amount to your policy allowed by the IRS to still receive tax benefits and front load your policy in the first several years for optimum earning potential and lifetime growth. 

THE MODIFIED ENDOWMENT CONTRACT

The IRS regulates how much you can contribute into an insurance policy over a certain time period and still retain tax advantages. Overfund your policy by too much, too quickly, and you run the risk of it becoming a modified endowment contract (MEC), which falls under less favorable tax rules. 

A paid-up additions rider, in conjunction with a whole life insurance policy, is designed to help prevent a policy from becoming a MEC by increasing your policy’s death benefit as you continue to contribute toward its cash value, maintaining the minimum required ratio of death benefit to cash value required by the IRS over any 7-year period. 

This 7-year period can be viewed another way: as a 7-pay test. In fact, since 1983, all life insurance policies have been required to meet the 7-pay test to avoid becoming MECs. Prior to 1983, people were purchasing life insurance with very small death benefits, making substantial up-front payments instead of annual premiums, and enjoying the increased tax benefits applied to their accumulated interest and dividend growth. Realizing the policies were essentially tax shelters, the IRS modified its tax code to measure the amount of premiums paid into a policy over 7 years relative to the amount of the death benefit. 

Every policy is different as far as how much cash value is considered “too much” by the IRS, as each policy has a different face value and premium, based on age and health. An ideal whole life policy structured for growth will overfund just under the 7-pay limit, as it pertains to the individual policy. Typically, the cash value should be around 80-90% of the premiums paid within the first 7 years for optimal growth, with very little premium going toward the death benefit.

Should you have temporary insurance needs, like outstanding loans, a mortgage, or business obligations that require additional financial protection, it’s possible to add an inexpensive term policy onto your whole life insurance policy, giving you the temporary coverage (additional death benefit) you need now without any long-term commitments or drain on your cash value accumulation. 

HOW OVERFUNDED LIFE INSURANCE IS USED BY THE WEALTHY

While you don’t have to be wealthy to utilize private banking with whole life insurance, the wealthy typically use overfunded insurance policies to accomplish these goals:

  • Traditional role of death payout. The original purpose of insurance, dating back to the 1800s. If something unexpected happens, there’s a payout.
  • Liquid assets in case of emergency. Money withdrawn or loaned against the policy can be used for an unexpected event, such as a medical emergency or job loss, and there are no age-related penalties for accessing funds.
  • Asset protection. As a private contract between you and your insurer, your policy and its cash value are protected from creditors and legal action in most states. 
  • Guaranteed loan provision. You can borrow against the policy to take advantage of any purchase opportunity—including business, investment, or personal—that requires liquidity and fast action.
  • Retirement savings. Without the contribution caps of 401(k)s or other qualified savings plans, overfunded life insurance is a safe option for retirement savings that is protected from market volatility and is accessible for early retirement before age 59 ½ without penalty. 
  • Tax-advantaged wealth. Life insurance, compared to alternatives, has some of the most lucrative tax benefits, as follows:
    • Beneficiaries. The payout of life insurance to a beneficiary is income tax-free. It is also estate-tax-free if the overall estate falls under a certain level.
    • Cash value. The growth of cash value is tax-deferred and can be used tax-free in some instances.
    • Policy loans. The funds received from a policy loan are not subject to income tax.
    • Withdrawals. Withdrawals of cash value, called partial surrenders, are tax-free up to the basis (overall amount contributed to the policy). 

In fact, overfunded whole life insurance is held as a Tier 1 Asset by nearly every major bank in the USA and has been used by the likes of McDonald’s and Walt Disney as a source of business capital.

SETTING UP YOUR POLICY

Provided you have a steady income, are in reasonably good health, and can commit to your long-term financial goals, overfunded life insurance may be a key part of your financial portfolio. If you’re a business owner, overfunded life insurance is nearly essential to securing the longevity of your company. And if you’re currently maxing out other retirement savings options or are looking for more reliability than Wall Street, a properly structured whole life insurance policy is almost certainly the way to go. 

The Wealth Strategists at Paradigm Life are experts in overfunded life insurance and can help facilitate policies in all 50 states and Canada. Schedule a complimentary consultation today to learn more about how this financial tool can benefit your wealth building strategy as it pertains to your unique financial goals and budget. Your goals are our goals, and we’re with you every step of the way.