Understanding section 7702 plans

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Are you in the market for a retirement plan? The first thing to know is a 7702 plan does not really fit into that category. A 7702 plan is a tax-advantaged life insurance policy. While some forms of life insurance can be used for investing and retirement, keep in mind that the main purpose of life insurance is to protect your loved ones from financial hardship.

The name of the plan, 7702, is a marketing tactic used by savvy insurance firms to sell life insurance. When you see an insurance plan sold under this name, the actual plan will be a specific kind, such as a whole life policy or a universal life policy.

It is important to know which kind of life insurance you buy, because each policy type handles the premiums you pay into the plan differently. The funds contributed to life insurance policies are not pre-taxed like with 401(k) or 403(b) plans. So if you are looking into a 7702 plan primarily for retirement savings, a 401(k) is probably a better place to start.

What is Section 7702

Section 7702 of the Internal Revenue Code defines the criteria that cash value life insurance policies must meet to retain their tax-advantaged status. This section outlines the guidelines for premiums paid and defines the corridor and cash value accumulation tests that must be satisfied in order for the cash value inside a permanent policy to grow on a tax-deferred basis. Section 7702 rules apply to any cash value life insurance policy that was issued after 1985. Section 7702 is therefore a code, not a plan in and of itself.

The term “7702 plans” does not refer to qualified plans in any sense, and any cash value life insurance policy you buy is subject to the same tax rules.

Why is Section 7702 important?

Section 7702 matters because it dictates which types of cash value life insurance policies are eligible to receive tax-advantaged treatment. If a life insurance policy does not meet the criteria listed in this section of the Internal Revenue Code, then both the growth of the cash value inside the policy and the death benefit will be counted as taxable income to the beneficiary. The majority of life insurance policies today meet the criteria of this code, so this is seldom an issue for policyholders.

Section 7702 in the Internal Revenue Code was created in response to the large number of life insurance policyholders who were using cash value life insurance as a tax shelter. Many policies that were issued before 1985 offered enormous growth potential in their cash value component, and the IRS sought to put a stop to this by implementing Section 7702 rules. Since 1985, life insurance cash values have had certain limits that must be followed in order to retain their tax-advantaged status.

What are Section 7702 plans?

As mentioned previously, Section 7702 “plans” are not really plans at all. They are standalone, privately issued cash value life insurance policies. Some insurance agents may have called them by this name so that clients thought that they were enrolling in a type of qualified plan. But there is nothing qualified about Section 7702 plans, and they bear no relation to real qualified plans such as 401(k) plans. An important difference is that 401(k) plans allow for pretax contributions (unless it is a Roth plan), while 7702 plans are funded with after-tax money. Contributors to a 7702 plan cannot deduct the cost of the premiums that they pay because the IRS views them as a personal expense and not as a retirement plan contribution. The cash value in these policies does grow tax-deferred and policyholders can take out tax-free policy loans from them. But this is the case for any cash value policy, regardless of whether it is called a 7702 plan or not.

A 7702 plan can be a whole life policy, a universal life policy, a variable universal life policy or an indexed universal life policy. The amount of cash value that accumulates inside the policy depends on which type of policy it is and the amount of premium that is paid into it over time. Variable policies have the potential for higher growth in the long run, but they can also decline in value when the markets drop. Indexed universal life policies are safer because the policyholder’s cash value is guaranteed not to go down if the underlying financial benchmark index that the policy is tied to does not perform well. However, they also do not have the same growth potential over time that variable policies can have. But the death benefit with these plans, or policies, is always tax-free regardless of what kind of policy is used.

How is a 7702 plan different from a retirement plan?

A 7702 plan refers to a cash-value life insurance policy, which is a life insurance policy that has a cash value beyond the death benefit. When you pay premiums into these kinds of policies, some of the premium goes to the death benefit and some of the premium goes to the policy’s cash value.

One of the main reasons why someone may want to reconsider buying a cash-value life insurance policy for the purpose of investing is that these policies can come with expensive management fees, mortality and expense charges and administrative expenses that can contain agent commissions. Sometimes these commissions can total 130 percent to 150 percent of the first year’s premium, which some people may view as a high price for the investment.

On the other hand, qualified retirement plans, such as a 401(k) received through your employer, generally come with no commission you have to pay to enroll in the plan. However, this does not mean that there are no fees involved with a 401(k) or other qualified retirement plans, such as a Roth account. You should always pay close attention to the terms of whatever retirement plan you consider to ensure you understand the cost of the plan.

How well a 7702 plan performs compared to other retirement plans depends on the investments made with the funds you contribute to the plan. Whatever plan you choose, it is a good idea to have a firm understanding of the investments your money is tied up in.

Frequently asked questions

What should I do if someone tries to sell me a 7702 plan?

Any life insurance salesperson or financial planner who refers to a cash value life insurance policy as a 7702 plan should probably be viewed with suspicion. But in all fairness, cash value life insurance policies can be used as retirement savings vehicles, but the policyholder should probably look at other avenues of saving for retirement before buying a policy for this purpose.

How do I know whether a given cash value life insurance policy that I look at conforms to the rules laid out in Section 7702?

Virtually all cash value life insurance policies today conform to the rules prescribed in this section of the tax code. Policies that fall outside of this jurisdiction are virtually nonexistent in today’s financial marketplace. Any reputable life insurer will only offer policies that adhere to this code. It is therefore not likely that you will come across a policy that fails to meet this criteria. If a policy does fail to meet this criteria, then the life insurance company should make that very clear in its sales materials.

Written by
Julian Dossett
Insurance Contributor
Julian has three years of experience writing for insurance domains including Bankrate, NextAdvisor with TIME, The Simple Dollar, Reviews.com, and Coverage.com. He writes about auto, home, and life insurance.
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