Premiums and Overfunding Life Insurance
“At that time the kingdom of heaven will be like ten virgins who took their lamps and went out to meet the bridegroom. 2Five of them were foolish and five were wise. 3The foolish ones took their lamps but did not take any oil with them. 4The wise, however, took oil in jars along with their lamps. 5The bridegroom was a long time in coming, and they all became drowsy and fell asleep. 6″At midnight the cry rang out: ‘Here’s the bridegroom! Come out to meet him!’ 7″Then all the virgins woke up and trimmed their lamps. 8The foolish ones said to the wise, ‘Give us some of your oil; our lamps are going out.’ 9” ‘No,’ they replied, ‘there may not be enough for both us and you. Instead, go to those who sell oil and buy some for yourselves.’ 10″But while they were on their way to buy the oil, the bridegroom arrived. The virgins who were ready went in with him to the wedding banquet. And the door was shut. 11″Later the others also came. ‘Sir! Sir!’ they said. ‘Open the door for us!’ 12″But he replied, ‘I tell you the truth, I don’t know you.’ 13″Therefore keep watch, because you do not know the day or the hour.” (Matthew 25:1-13)
All the benefits of life insurance are funded by the premiums you pay in. This is where the text above comes in: successful life insurance strategy is all about preparing now for what you will need later. There are two basic types of premium. There is the initial company mandated minimum premium, and then there are additional funds that you can pay in. We’ll talk first about the minimum premium and then look at the extra premium.
Premiums are planned to be paid in every year going forward (some will cap out after a certain number of years while others will give you the option of suspending paying premiums, but you want to pay in as much as possible). They can be paid monthly by bank draft, quarterly, semi-annually, or annually.
Whole life policies will earn dividends and the most common way (and usually the best at least early on) to apply these dividends is to have them buy paid up additions to the policy. This is a way of using your dividends to pay extra premiums so that they are buying you even more benefit (both cash value, death benefit, and future dividends).
After a certain number of years of doing this that cannot be predicted from the outset, but are perhaps around 12 to 15, the policy is fully capable of paying for itself so that you never have to pay another premium if you do not want to. However, the better you understand the power of the policy’s benefits, the more you will want to continue funding it.
If something comes up earlier and you need to take a break from funding the policy, its possible as long as there is cash value to pay for this. It might be smartest to take a loan from the company (your guaranteed right as a policy holder) and pay the premiums with this money. We had a client come to us after only a couple years of paying into the policy who wanted to go back to school and was thus looking to reduce his expenses. It was possible for him to recycle the money within the policy for five years using loans before he would absolutely have to come up with new premium dollars. Each year that a premium was paid (using the loan funds) creating new cash value that could then support additional loans. Obviously, this is not the best plan, but it demonstrates the flexible possibilities that exist to meet the required premium.
Another thing that you can do is over fund the policy. This is when you pay in more than the required premium. These premium dollars do not work like the required premium dollars of the early years of the policy. They work much more similarly to premiums paid years down the road. Some of the premium paid in goes to pay for more death benefit face amount (which in turn will pay more lifetime dividends). Most of the premium paid in in this way goes straight into cash values. Designing your policy in this way can be used to jump-start it and begin enjoying many of the benefits of the policy much sooner.
But it is important to discuss Modified Endowment Contracts (MEC’s). The IRS understands that life insurance is a tax free vehicle, but they do have a limit on how much you can put into the policy before they begin to tax it. They feel that if you pass beyond a certain amount of money going into the policy then you are simply out for tax free growth and care nothing for the death benefit. Therefore if you do go beyond this line, they will tax any money taken out of the plan. For some people, this is a great solution, but for most, this is something to be avoided.
The MEC guidelines are complicated, but the insurance companies provide us with software that tells us how much you can put into the policy and stay just shy of this line. If the Government has established this threshold for exactly how much they will allow you to permanently avoid income taxes, perhaps you should take advantage of this?
Hopefully this didn’t come across as too heavy, but it was important to establish the basics of how the policy works. Tomorrow, we’ll start discussing the benefits of how these policies can really help you to steward your money in powerful ways.
This is Part 3 in a series on Whole Life Insurance. You might want to read the introduction to this series which will link to each post in the explanation of whole life and Ben’s story showing how whole life is used in a variety of ways in his life.
Photo credit: ranhar2