In this article, we’re going to discuss a strategy whereby someone can take advantage of overfunding their cash value life insurance policy for the purpose of then using this cash accumulation to grow and preserve wealth. During our discussion, we’ll focus on some of the pros and cons of overfunding life insurance, as well as identify when implementing such a strategy may be in one’s best interest.
So, let’s take a closer look at what it means to “overfund” life insurance and see if doing so might make sense for you.
What is Overfunded Life Insurance?
Overfunded life insurance (OLI) is a popular option for anyone looking to build substantial savings in a tax-favored compound interest account, via cash value life insurance. Sometimes referred to as a LIRP life insurance retirement plan, these overfunded life insurance policies are designed to offer maximum early high cash value accumulation along with the asset protection and tax benefits of life insurance.
Overfunded life insurance is essentially permanent coverage such as
- indexed universal life (IUL)
- whole life insurance (WL)
Overfunded life insurance is uses one of these cash value insurance products to contribute additional cash into the policy to immediately boost the policy’s cash value. This added cash value grows tax free in the policy’s cash value account and can be accessed via cash withdrawals or policy loans.
Design Matters
How you design an overfunded life insurance policy will make or break the policy. For any policy that you wish to overfund for the cash value growth, the key is to design the policy so that the majority of the premium payment goes towards the cash value component, rather than towards the death benefit.
Whether your preference is whole life, indexed universal life, or variable universal life, the key is to find an agent that understands how to properly structure your policy to make it as efficient as possible without the policy becoming a modified endowment contract (more on this below).
For example, a whole life policy designed for maximum cash value growth needs to have the correct amount of base premium and paid up additions. Only by structuring your policy will you be able to maximize the policy’s lifetime cash value growth.
With that introduction aside, let’s get to the advantages and disadvantages of overfunding life insurance.
Overfunded Life Insurance Pros and Cons
There are several overfunded life insurance pros but also some negatives to be aware of. Let’s start first with the benefits.
Top 12 Overfunded Life Insurance Benefits
- Tax Favored
- Dividend Payments
- Flexible Investment Options
- Market Downside Protection
- No Contribution Limits
- Tax-Free Loans and Withdrawals Up to Basis
- No Age Based Liquidity Restrictions
- State Asset Protection
- Tax-Free Death Benefit
- Disability Rider
- Living Benefits for Chronic or Terminal Illness
- Privacy
Tax-favored account growth
Funds in the cash value account of an overfunded life insurance policy, such as indexed universal life or whole life insurance, grow income tax free, which enables you to build up a larger amount of funds in such accounts for long-term savings goals than taxable accounts, all else equal.
Dividend Payments
Overfunded dividend paying whole life insurance policies offer annual life insurance dividend payments that can be used for a variety of purposes, including increasing your policy’s cash value and death benefit.
Flexible investment options
Overfunded indexed universal life insurance policies enable you to move your cash value into subaccounts linked to stock market indices such as the S&P 500, the NASDAQ 100, or a more conservative fixed interest rate option, while overfunded variable universal life insurance offers subaccounts which invest directly in a variety of stocks and other securities.
Market downside protection
One of the primary benefits of an IUL policy are that since your funds aren’t directly invested in the market, but rather in subaccounts which mirror the movement of a market index, you are protected from losses if the market declines in an indexed universal life insurance policy. These subaccounts typically set a floor of at least 0%.
While a variable universal life insurance policy typically provides a greater potential upside than an IUL, because VUL subaccounts directly invest in market securities they don’t offer the same downside protection if the market declines.
And overfunded whole life insurance is a non-correlated asset that is contractually guaranteed to go up in value each and every year.
No contribution limits (with certain exceptions):
Unlike retirement plans such as 401ks, there are no yearly or other caps on the amount you can contribute to an overfunded life insurance policy.
One limitation is that the excess cash added to the policy over any 7-year period must follow certain rules to avoid the policy being labeled a MEC modified endowment contract and losing its tax-favored status. Policy’s that are considered a MEC will lose some of its tax advantages.
Another contribution limit is determined by how much life insurance you can qualify for, which takes into account your age and income. The higher your income, the higher your insurable interest. However, the older you are, the lower your multiple of income multiplier will be.
Tax-free loans and withdrawals up to account basis
Whether you take a partial withdrawal from your overfunded life insurance policy or a life insurance loan, funds can be taken from your cash value account on a income tax free basis up to the point where withdrawals exceed contributions. This is due to the first-in, first-out tax status of insurance policies. In the case of a life insurance loan, you can borrow against your policy tax-free.
No age-based liquidity restrictions
Funds can be taken out of an overfunded life insurance policy before age 59 ½ for any reason without government-imposed penalties, unlike IRAs and 401ks (see 401k withdrawal rules).
Note, depending on the type of policy you have, there may be surrender charges for early withdrawals. Typically, an overfunded whole life insurance policy does not have surrender charges but universal life insurance typically does have surrender charges, at least for the first 10 years or so.
Asset protection
Unlike funds held in traditional investment accounts and trusts, assets held in a overfunded life insurance policy are protected from legal claims and creditors. Different states have different bankruptcy and creditor protections so be sure to inquire into your specific state.
Tax-free payout of death benefits to your beneficiaries
In addition to offering the ability to build up funds for retirement or other purposes in a tax-sheltered vehicle, these policies offer tax-free transfer of death benefit proceeds to your beneficiaries upon the death of the insured, and is a prime reason that overfunded permanent life insurance is a great wealth building asset.
Availability of a disability waiver
Many overfunded life insurance policies have disability waiver of premium riders which enable you to convert them into a form of living benefits if you are injured or otherwise unable to work. If you are disabled with a waiver of premium rider, the insurance company will pay your life insurance premiums.
Living Benefits for Chronic or Terminal Illness
Additional living benefits include long-term care riders and chronic illness riders. These living benefits allow you access to a portion of the death benefit for a qualifying chronic condition or terminal illness. And there is no requirement on how you spend the money as you are free to use the money from the policy for anything you need.
Privacy
Your overfunded life insurance policy’s cash value and death benefit, as well as any existing policy loan, is private and does not appear on a credit check.
Overfunded Life Insurance Drawbacks
While overfunded life insurance can offer a number of benefits, such as being able to set aside funds in a tax-favored vehicle, these types of policies are not for everyone. Some of the potential issues to consider when looking into purchasing an overfunded life insurance policy include:
Fees
Permanent life insurance policies used to fund overfunded life insurance typically feature higher upfront fees than term life insurance. However, overfunding life insurance provides benefits such as tax-deferral, loss limitation, and asset protection as described above.
Additionally, as the cash value in your account rises the impact of the fees on your funds as a percentage declines, making these policies most appropriate for those looking to set aside significant savings over a period of time greater than 10 years.
Surrender charges
In some overfunded universal life insurance policies, especially those funded for indexed unversal life and variable universal life, there may be surrender fees for withdrawing too much money out of the policy in the first 10 years or so. As mentioned above, this is typically not the case with overfunded whole life insurance.
Policy lapse danger
When borrowing from your life insurance using your cash value as collateral, you must take care to pay policy premiums to avoid lapsing your policy. If your overfunded life insurance policy lapses, your coverage will be cancelled and you may be subject to taxes on the money you borrowed from the insurance company.
Who Should Consider Overfunded Life Insurance?
Those Looking To Practice IBC
Infinite banking uses overfunded whole life insurance with a paid up additions rider for early high cash value growth that can be borrowed against as collateral for a loan. You can use the loan for anything you need it for, but many people use the proceeds to buy cash flowing assets, such as real estate investing or investing in a business.
High Net Worth
Overfunded life insurance is also well suited for higher net worth individuals such as business owners, corporate executives, or others who are capped out in their 401k contributions or do not qualify for a Roth IRA and want to set aside funds in an alternative retirement savings vehicle.
This is especially true if you have delayed retirement planning and are trying to make up for lost time by currently setting aside as much money as possible. Because overfunded life insurance is not subject to the contribution limits placed on government-supported retirement plans such as 401ks, you can generally set aside more significant sums of money in an overfunded policy, and why cash value life insurance has been coined the “Rich Man’s Roth.”
Glorified Savings Account
Such overfunded whole life insurance policies and universal life insurance policies (excluding VULs) also work well for anyone who wants a chance to realize returns equal to some portion of the upside of the stock market without the downside risk.
This scenario may apply to executives at public companies or other investors who have a significant amount of money at risk in the stock market and desire to have asset protection in high volatility stock market years.
The ability to pull living benefits from onverfunded life insurance makes such plans an effective way to help protect your current income while setting aside funds that can provide you with additional retirement income.
Overfunded Life Insurance Example: Jim Harbaugh
An example of how overfunded life insurance can be used to provide tax-advantaged income along with a death benefit payout for a person’s beneficiaries comes from the contract signed by Jim Harbaugh which, using figures compiled by USA Today, made him the highest-paid college football coach in the country.
His contract featured a package including deferred compensation in the form of an overfunded indexed universal life insurance policy. The IUL policy will enable him to save millions in tax-free retirement benefits in conjunction with a split-dollar loan agreement funded by the cash value of the IUL.
The split-dollar agreement specifies that the University of Michigan will pay a total of $14 million in loan advances, in seven payments of $2 million each, into the overfunded cash value life insurance policy.
Establishing such an overfunded policy means that Harbaugh will not need to repay the policy loan prior to his death, at which point the coach’s beneficiaries will get the remaining death benefit.
During his lifetime, Harbaugh can borrow money from the insurance company using the overfunded policy’s cash value as collateral without paying income tax. It is estimated that this approach will enable Harbaugh to start receiving $1.4 million each year from the policy income tax free starting at age 66.
Conclusion
There are few, if any, savings vehicles that offer the benefits of overfunded life insurance. If you are looking for a safe bucket for your assets, an alternative income in retirement, or desire to “become your own banker” using life insurance, then an overfunded cash value life insurance policy is an amazing vehicle to help you achieve financial independence and security.
At I&E, we specialize in overfunded life insurance. We can help you create the best overfunded life insurance policy for you, based on your specific needs and objectives. You can reach out to one of our Pro Client Guides or call us today for a complimentary strategy session to see what we can do for you.
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