Understanding Overfunded Life Insurance

Pros and cons of overfunding your life insurance policy

Overfunding your life insurance policy can provide financial benefits, but there are also some drawbacks to consider:¹

Pro: Accumulate cash value more quickly

Overfunding your life insurance policy helps you build cash value more quickly. Not only does your principal amount increase, but you may maximize the impact of compound interest. This could accelerate your growth, letting you access your funds faster. If you have a variable life insurance policy and feel confident in your investing knowledge, you could potentially earn significant gains if your investments perform well.

Pro: Access your cash value in several ways

Overfunding life insurance is part of a strategy called “infinite banking,” which treats the policy like a bank account.² You pay more in premiums to help save extra in the cash value, then access the cash value via no-credit-check loans with low interest rates and no fixed repayment dates. This lets you borrow at better rates and terms than through a bank, which can help you with large purchases or to refinance other debts. You can also withdraw from the cash value to help avoid more debt, but you may reduce your death benefit or experience tax consequences.

Additionally, overfunding life insurance policies that pay dividends let you earn more dividends whenever a dividend is announced. You can use dividends in several ways:

• Receive the dividends as cash
• Save the funds in an insured-managed interest-bearing savings account
• Use the funds to pay premiums
• Purchase paid-up additions to your coverage, helping to boost your cash value even more

Furthermore, if you surrender your policy, you can receive your cash value minus surrender charges.

Pro: Tax benefits

Cash value offers several tax benefits:

• Tax-deferred growth: Interest or gains you earn are tax-deferred as long as the cash value stays in the policy. By minimizing taxes, you can help grow your cash value faster. This differs from savings and brokerage accounts, where earnings may be taxed.


• Loans: Loans are generally tax-free as long as the policy doesn’t lapse. This, combined with the low interest rates, makes policy loans similar to a simple withdrawal.


• Withdrawals: Withdrawals up to the total premiums paid are generally tax-free.³ For example, if your cash value is $22,000, and you’ve paid $20,000 in premiums, you could potentially withdraw up to $20,000 tax-free while letting your earnings earn more.

Con: Complexity

Overfunding a life insurance policy and treating it as a savings vehicle may complicate your financial planning since you must incorporate another account into your overall financial picture. Tracking cash value growth, loans, and withdrawals alongside your other savings, investments, and debts may take more effort. Furthermore, there may be tax consequences in certain conditions, complicating your tax situation.

Con: Your policy could become reclassified as an MEC

A life insurance policy may become a modified endowment contract, or MEC, if the cash value grows beyond IRS limits. MEC reclassification strips the policy of the tax benefits associated with policy loans and withdrawals.⁴ This exists to help prevent insurers or policyholders from calling a financial product “life insurance” to get tax advantages that they otherwise would not have with such a financial product. A policy is considered an MEC if it meets the following criteria:⁴

• You entered into the policy on or after June 20, 1988
• It meets the statutory definition of a life insurance policy
• It fails to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) "seven-pay test"

The seven-pay test measures how much you would need to pay within the first seven years of policy ownership to maintain full coverage. It then compares that against how much you actually paid to see if you overpaid and should have the policy reclassified. Failing this test, meaning you paid more than the seven-pay test amount, can turn your policy into an MEC.

Con: Fees

Paying more into the life insurance policy can raise certain fees besides the fact that you’re paying more in premiums:

• Administrative fees: The insurer may raise administrative fees to manage the increased cash value.


• Mortality and expense risk charges: These are based on the policy’s value, so they may increase if you overfund the policy.


• Surrender charges: Surrendering the policy earlier to get your full cash value that you accumulated faster can result in higher surrender charges, reducing your payout.

Is overfunding a life insurance policy right for me?

Overfunding a life insurance policy can help some policyholders, but it’s not right for everyone. Here are a few factors to consider when deciding if you should overfund your life insurance policy:

• Financial goals: Overfunding a policy could make sense if you need to grow savings faster. The faster tax-deferred growth could accelerate your savings.


• Budget: Overfunding life insurance requires bigger premium payments and higher fees, so it may not work if it could compromise other financial obligations.


• Tax implications: Weigh the potential tax benefits against the risk of MEC reclassification before overfunding.


• Policy type: You can’t overfund term life insurance. For permanent policies, consider the policy type and how its cash value works. For example, if you have a variable policy, you may avoid overfunding if you are confident in your ability to select investments with high growth potential.


• Financial confidence: Overfunding adds complexity to your policy. Make sure you are confident in managing the overfunding and cash value to avoid MEC reclassification and to make the most of your cash value.

Learn more about life insurance

Overfunding your life insurance policy can offer you an additional wealth-building vehicle, but you must be cautious about the downsides. Consider your financial situation and the risks of MEC reclassification before pursuing an overfunding strategy.

If you want to learn more about cash value life insurance policies or explore your coverage options, Aflac is here to help. Contact an agent today to learn more and get a quote.