What Is an Overfunded Life Insurance Policy?
The Trick: Avoid MEC Status
As with all things that sound too good to be true, you’re probably wondering: what’s the catch? And there is one – so if you Googled “what is an overfunded life insurance policy” hoping to find a get-rich-quick scheme, this isn’t it.
Because of the tax benefits of overfunding your policy, the IRS put rules in place governing how and when you can overfund and still reap all those benefits.
IRS rule 7702 is designed to keep you from overfunding your account for the first seven years you own the policy. During that time, if you overfund your account with more than your required payments, your policy could be reclassified as a modified endowment contract (MEC). Once your policy is reclassified, the tax benefits for cash value are greatly diminished:
Non-MEC: You can access your cash value via a withdrawal or policy loan up to the amount you’ve paid into the policy with zero income tax obligation. If you pull out more than you’ve put in, you only owe income tax on the overage. While in your account, the money continues to grow tax-deferred.
MEC: Any cash value you pull out via a withdrawal or policy loan would be subject to income tax, no matter how much you’ve paid into the policy. While still in your account, however, the money continues to grow tax-deferred.
Your best strategy? Wait out the first seven years, during which the IRS rule 7702 applies. After that point, you can contribute as much as you want to overfund your policy without the worry that it could be reclassified.
If you want to use whole life insurance to grow wealth, for example, it’s key to be sure your policy is not structured as a MEC from the get-go, and to avoid doing anything that could trigger that reclassification.
