Does ‘Overfunding’ Life Insurance Policies Beat Buying Stocks?

overfunding life insurance

Purchasing a life insurance policy is a great way for a head of household to ensure loved ones will be financially secure after death. However, some people have found ways to use insurance policies as an investment as well.

While investing in life insurance is perfectly normal, some policyholders are taking part in a practice known as overfunding to build greater wealth, even if it takes some money away from their beneficiaries upon death. Is this investment idea truly beneficial?

What Does Overfunding Life Insurance Mean?

Life insurance has long been considered an investment tool for some policyholders. While term life insurance policies typically don’t offer investment options because they are strictly used as a way to provide a set payout for beneficiaries at the time of a policyholder’s death, most permanent life insurance policies offer the option of setting aside some of the premium payments in investment funds to be withdrawn or used in other manners before death.

There are other benefits to purchasing permanent life insurance policies. Unlike term policies, they never lapse as long as you keep up with your payments. However, one of the biggest benefits for some policyholders is the ability to overfund their policies.

What exactly does it mean to overfund a life insurance policy? It could mean anything from increasing annual premium payments to making a lump sum in order to earn greater returns on policy investments down the road.

Suppose at 30 years old, you purchase a $500,000 permanent life policy; in this case, whole life insurance. Let’s say your premium for this policy is about $6,000 per year. In a typical cash-value life insurance policy, your company will place a portion of your yearly payment into index mutual funds and other investments that will grow returns over time.

If you choose to surrender your policy before death, the excess premium and earnings are returned to you. It’s for this reason that some are choosing to overfund their accounts. By adding $10,000 or more additional per year to their premiums, they’re hoping to surrender the policy and earn greater returns in the long run.

Is Investing in Life Insurance Better than Traditional Investing?

For individuals who have considered overfunding life insurance policies instead of using the traditional investing vehicles, it’s good to take a closer look at how both might impact your bottom line.

First, let’s explore some pros and cons of overfunding a policy:

  • Pros–Forced Savings and Tax-Deferment: One benefit of overfunding your life insurance policy includes receiving forced savings, meaning your investment vehicle by its very nature requires you to save money. Another benefit is tax deferment, which means you don’t have to pay taxes on the investments within your policy year-over-year as long as you don’t withdraw the money.
  • Con–Costly with No Guarantees: Many people who choose to overfund a life insurance policy hope to use some or all of their cash value to pay premiums down the line or withdraw it in a lump sum. This option is costly due to the higher price of the policy itself, the extra money you’re investing and the higher investment fees. Also, there are no guarantees the policyholder won’t die before cashing out the money. If this happens, the beneficiary will only receive the originally intended payout.

Now assume you take the same $6,000 plus addition $10,000 per year that would have been used to overfund the policy and instead invest it Treasury Bonds. In 2010, the annual return on T-Bonds was around 8 percent. Let’s say you earned this average yearly from age 30 to 60. In 30 years, you would have earned over $518,000–more than the entire value of your policy–with more years to earn if you keep on trucking.

Also, it’s good to keep in mind that when you add funds to your life insurance policy, it is not a pure investment. Some goes toward the cost of insurance protection itself, as well as marketing and sales commissions and investment fees.

It’s for this reason that some say overfunding is not for everyone. It’s usually better suited for people who are looking for investments that will last at least 15 to 20 years and have substantial wealth–usually in the ballpark of $5 million or more–and are not looking at this one option as their meal ticket. In other words, it’s best to try this only if you can afford to lose your cash out by dying before claiming it.

For everyone else, the safer and more financially rewarding route is setting up a diversified portfolio that includes mutual funds, bonds, stocks and more.

Unless you have millions to work with, it’s a good idea to allow your life insurance policy to function as a tool for financial security for your family. And if you want to build your retirement and investment savings, talk to a financial advisor about how you can earn amazing returns the traditional way.