Overfunded life insurance: Balancing the pros & cons

Life insurance can provide financial security for your family in the event of your untimely death. But certain kinds of life insurance also can help you build wealth that you can access while you're alive, or leave as an inheritance.

If you're looking for ways to grow and pass along your wealth, one strategy is overfunded life insurance. This involves paying more than needed in premiums to build up your contract's cash value.

However, it isn't a good strategy for everyone. Let's explore what it means to overfund your life insurance and how to decide if it makes sense for you and your family's financial situation.

Overfunding life insurance is when you pay extra into your permanent life insurance beyond the basic premium. In doing this, you can accumulate cash value more quickly. Like any investment, overfunded cash value life insurance has the potential for compound growth over time. You also can take tax-advantaged withdrawals from your contract's cash value or a policy loan.

When properly managed, cash value grows tax-deferred. And withdrawals and loans from your policy's cash value are not subject to income tax. So, as long as your contract doesn't become a modified endowment contract (MEC), withdrawals are taken on a first-in, first-out (FIFO) basis and policy loans are not subject to income tax.

“The primary attraction to overfunding a life insurance policy is to achieve faster growth in your cash value," says Kevin Foseid, life product consultant at Thrivent. "You might decide to take this approach if you anticipate a need to access the cash value while still alive. For example, you might use the cash value as a means of supplemental income during retirement, especially during a period where the stock market is down in value."

You can typically overfund permanent life insurance contracts that build cash value, such as whole life, universal life and variable universal life. You can't overfund term life insurance because it doesn't build cash value.

Not every permanent life insurance contract allows overfunding, or there may be a limit on how much extra you can pay. The rules and benefits around overfunding can vary among insurers and individual contracts, so be sure to review the specifics of your particular agreement.

Yes. Putting extra money into your life insurance can be an advantageous strategy, but in certain cases, you may run the risk of having the IRS reclassify your contract as a MEC.

An overfunded life insurance contract becomes a MEC when the premiums paid exceed federal tax law limits. This limit is based on the "seven-pay test," which compares the total premiums you paid in the first seven years of the contract with what you would need to pay in full. If your payments exceed what's required, the IRS reclassifies it as a MEC.

If your contract becomes a MEC, you owe taxes on withdrawals and loans from the contract. You also could owe a 10% penalty on withdrawals if you're under 59½ when you take cash out. Withdrawals and loans are treated on a last-in, first-out (LIFO) basis, meaning any gains are subject to income taxation as well as a 10% penalty for taxable distributions prior to 59½.

Putting the right amount of extra money toward your life insurance's cash value can seem like an appealing option for saving and investing for the future, but it helps to compare the benefits and drawbacks.

• Access to cash. Overfunding a life insurance contract can provide a pool of tax-advantaged money you can access during your lifetime through withdrawals or loans.
• Tax-deferred growth. Overfunding life insurance can accrue significant cash value, and you don't have to pay taxes on those investment returns until you withdraw the funds.
• Tax-advantaged death benefits. Life insurance contracts pay out tax-advantaged death benefits to beneficiaries after the contract holder dies.

"For example, along with the cash value growth, overfunding in a whole life contract can help assist the dividend in growing your death benefit through the purchase of paid-up additions," Foseid says.

• Risk of creating a MEC. If your contributions exceed federal limits, your contract could turn into a MEC, changing the tax treatment of distributions.
• Fees. Permanent life insurance contracts typically have higher fees than term life insurance. Those fees could reduce any potential return on your investment.
• Complexity. Overfunded life insurance contracts can be complex. They require careful management and understanding of the rules to avoid tax pitfalls.

While overfunding life insurance can have benefits, it may not be the best strategy for everyone. Other financial strategies can provide similar advantages without the potential drawbacks of overfunding. A few alternatives you might consider include:

• Traditional investments: Stocks, bonds, exchange-traded funds (ETFs) and mutual funds may provide higher returns over the long term than a cash value life insurance contract.

• Retirement accounts: Tax-advantaged retirement accounts like 401(k)s or individual retirement accounts can provide significant tax benefits. Your contributions may be tax-deductible, and your investments grow tax-free until retirement.

Overfunding life insurance can help you build tax-deferred wealth and cash reserves. However, it's not the right strategy in every situation. If you tap into the cash value and then can't pay the premiums, your contract typically will be canceled, and you'll have to pay taxes on any contract loans.

Consider meeting with a Thrivent financial advisor to get personalized advice that considers your unique circumstances and goals.