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Whole life insurance and other permanent policies can help to provide a financial cushion for your loved ones after you've passed. While the primary benefit of any life insurance policy is the death benefit, there may be other ways that a policy can help you work toward your own financial goals. For example, some people overfund their life insurance policy for various reasons. Here's some information on how overfunded life insurance works and who this strategy could be right for.
What Is Overfunded Life Insurance?
Overfunded life insurance is when you pay more into a policy than is required. Permanent life insurance policies, such as whole life insurance or universal life insurance, have a cash value component. So, by overfunding your policy, you contribute more to the cash value.
You typically need to pay a certain premium each year or each month to ensure that the policy stays in force and that your beneficiary will receive the death benefit. However, if you pay more than the minimum amount required, the cash value of your policy typically grows.
Keep in mind that different policies have different rules, and there are limits on the maximum amount that can be paid into a policy. You'll likely want to discuss overfunding your policy with a financial representative. A tax professional can also help you ensure that you won't owe additional taxes or encounter other tax-related problems.
When Might You Overfund a Life Insurance Policy?
Overfunding an insurance policy might make sense in some situations. Here are a few examples.
You Plan to Access Cash Value
Overfunding a life insurance policy might be beneficial if you plan to use the policy's cash value later in life. Since you can typically draw from your permanent policy's cash value in the form of loans or withdrawals, overfunding the policy could potentially increase the amount of money that's available later on. Just keep in mind that loans or withdrawals may generate an income tax liability, reduce the cash value and death benefit, and cause the policy to lapse. Loans will also accrue interest.
You Want to Manage Taxes
As mentioned before, life insurance policies have unique tax features. There are a couple ways that overfunding your life insurance policy could help to provide tax benefits, but there are also potential consequences to consider.
Potential for growth without tax liability: You typically do not pay income taxes on the interest you earn inside of a life insurance policy. However, gains are taxable when you take a withdrawal. That's different from interest you earn in taxable bank and brokerage accounts, which require you to report those earnings to the IRS each year.
No annual IRS limits on additions: The IRS does not set a yearly limit on how much you can contribute to a life insurance policy. That said, there is still a limit to how much you can pay into a life insurance policy before you assume tax liability. If you go over that maximum limit, you risk having a Modified Endowment Contract (MEC), which could lead to losing the favorable tax treatment you otherwise receive with a cash value life insurance policy. The maximum limit may depend on the death benefit and other factors, and there may be limitations based on the policy you purchase.
The tax features of a life insurance policy can be complicated, so it's important to review your strategy with a tax professional and your financial representative before making any decisions.
The Bottom Line
Overfunding a life insurance policy may be the right move for some people. However, this strategy isn't right for everyone, so consider speaking with your financial representative and a tax professional as you map out what's best for you.