Harry N. Stout
323- What is “Overfunded” Permanent Life Insurance?
By: Alan S. Lurty, Fellow of the Life Management Institute, Retirement Income Certified Professional, and Wealth Management Certified Professional
As a consumer, you may have thought about protecting your family from the unexpected with life insurance. But did you know that permanent life insurance can also provide a source for retirement income on a tax-advantaged basis?
First, a caveat: We are not providing tax or legal advice in this post. You should consult with a tax or legal professional to discuss your own particular situation.
Financial professionals often utilize permanent life insurance (which builds cash value over time, such as whole life or the various forms of universal life, as opposed to term insurance) for just such a purpose. The approach relies on the tax-favored status of life insurance in the United States. In general, death benefits from a life insurance policy are not taxable as income to the beneficiary.
You may not know that as cash value builds in a permanent policy, the annual increase in value (known as the inside build-up) is not taxable as income to the policy holder in that year. So it continues to build on a tax-deferred basis over time. If the policy is surrendered at some point in the future, the cash value in excess of the premiums paid is treated as taxable income to the owner in the year of surrender.
However, the other key aspect is that if the life insurance policy is kept in force, when withdrawals are made from the cash value (for example, to create a stream of retirement income to the policyowner), the withdrawals are treated first as a non-taxable return of premium until the point at which the total withdrawals equal the total premiums paid into the policy, and only then are the remaining withdrawals treated as taxable income.
Although the technical details are beyond the scope of this short post, the taxation on those later withdrawals can potentially be avoided through the use of policy loans, although you will want to discuss this with your financial professional to ensure that the approach is structured properly.
Now here’s where the "overfunded” aspect comes into play. Because the premiums on a universal life policy are flexible (and there are mechanisms for whole life policies to achieve a similar result), instead of paying the regular projected annual premium on the policy, you can “stuff” the policy with higher premiums for a given amount of insurance, up to certain limits defined by the IRS (your advisor will be aware of these limits, which will be shown in the policy projections). In doing so, the cash value grows faster, and because of the growth, the internal charges in the policy to cover the cost of the insurance coverage are reduced, further enhancing the cash value growth.
Your advisor can show you examples for your own specific situation but using this approach it’s not uncommon to see premiums paid typically for anywhere between five and 20 years, and then because of the tax-advantaged growth in the policy, having withdrawals (typically beginning in retirement) that can last for 10 to 20 years or even longer. This is on top of the protection provided by the life insurance itself in the form of the policy’s death benefit. Professionals often use this approach as a supplemental source of retirement income for clients, particularly those who have maxed out contributions to 401(k) and other retirement savings plans.
In summary, it’s a good idea to talk to a financial services professional about this strategy. I hope this helps explain the issue. Please reach out on the site with any questions!
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