Understanding section 7702 plans
A 7702 plan is a tax-advantaged life insurance policy named after the Internal Revenue Code section that explains how cash value life insurance policies retain their tax-advantaged status. A 7702 plan, contrary to its name, is not a type of life insurance policy, such as term or whole life.
It is critical to understand the type of policy you choose and how your premiums will be handled before signing a life insurance contract. This includes any potential tax benefits from the policy's cash accumulation. You can better understand a policy's tax-advantage status and the impact on your cash value account by learning about the Section 7702 code.
What is Section 7702?
Section 7702 of the Internal Revenue Code specifies the requirements that cash value life insurance policies must meet in order to continue to be tax-favored. This section 7702 code defines the premium payment guidelines as well as the corridor and cash value accumulation tests that must be met for the cash value of a permanent policy to grow tax-deferred.
Section 7702 rules apply to any cash value life insurance policy issued after 1985, according to the guidelines below:
- To qualify for tax breaks, you must pass two "tests": the cash value accumulation test (CVAT) (or the guideline premium) and the corridor test (GPT).
- If a contract fails to meet the guidelines, the policy proceeds are treated as income.
In no way does the term "7702 plans" refer to qualified plans, and any cash value life insurance policy you purchase is subject to the same tax rules.
What is a Cash Value Accumulation Test (CVAT)?
Section 7702 outlines and defines the CVAT as one of the tests. The cash value test is met "if the sum of the premiums paid under the contract does not at any time exceed the guideline premium limitation as of that time," according to the code. This means that the money a policyholder receives if they decide to cancel their policy cannot be more than what they would have paid for the policy in a lump sum, excluding fees. The cash surrender value is the amount of money received by the policyholder in the event of cancellation.
Term life insurance is an example of a policy that would pass the CVAT test. Term life insurance, unlike whole, universal, and variable policies, does not accumulate cash value. If you surrender your term life insurance policy, you will not receive any payout. Because most term policies do not have a cash value component, premiums for term life insurance are typically less expensive.
Why is Section 7702 important?
Section 7702 is an important code because it specifies which types of cash value life insurance policies are eligible for tax benefits. If a life insurance policy fails to meet the criteria outlined in this section of the Internal Revenue Code, both the growth of the cash value inside the policy and the death benefit are taxable to the beneficiary. Because the vast majority of life insurance policies today meet the criteria of this code, policyholders are rarely inconvenienced.
Section 7702 of the Internal Revenue Code was enacted in response to the large number of cash value life insurance policyholders who used it as a tax shelter. Many policies issued prior to 1985 had enormous growth potential in their cash value component, which the IRS attempted to prevent by enacting Section 7702 rules. Since 1985, there have been set limits on life insurance cash values that must be adhered to in order to maintain their tax-advantaged status.
How Section 7702 plans work
As previously stated, Section 7702 "plans" are not individual types of life insurance policies. They are stand-alone life insurance policies with a cash value. Some insurance agents may have referred to them as "7702 plans" to assure clients that they were enrolling in a type of qualified plan with tax benefits.
However, 7702 plans are not the same as traditional retirement plans such as 401(k)s or individual retirement accounts (IRA). A significant distinction is that 401(k) plans accept pretax contributions (unless they are Roth plans), whereas 7702 plans accept after-tax contributions. If you contribute to a 7702 plan, you cannot deduct the cost of the premiums you pay because the IRS considers them a personal expense rather than a retirement plan contribution. The cash value of these policies grows tax-deferred, and policyholders can borrow against them tax-free. However, this is true for any cash value policy, whether or not it is referred to as a 7702 plan.
A 7702 plan can be a whole life insurance policy, a universal life insurance policy, a variable universal life insurance policy, or an indexed universal life insurance policy. The amount of cash value accumulated within the policy is determined by the type of policy and the amount paid into it over time. Variable policies have the potential for higher long-term growth, but they can also lose value when markets fall. Indexed universal life policies are generally safer because the policyholder's cash value is guaranteed not to fall if the underlying index performs poorly. They do, however, have a lower long-term growth potential than variable policies. Section 7702-qualifying policies have tax-free death benefits regardless of the type of policy used.
How is a 7702 plan different from a retirement plan?
A 7702 plan is a cash-value life insurance policy, which is a life insurance policy with cash value in addition to the death benefit. When you pay premiums into these policies, some of the premium goes to the death benefit and some goes to the cash value of the policy.
One of the main reasons why someone might want to think twice about purchasing a cash-value life insurance policy for the purpose of investing is that these policies can come with high management fees, mortality and expense charges, and administrative expenses that may include agent commissions.
Qualified retirement plans, such as a 401(k) through your employer, on the other hand, generally do not require commission fees to enroll in the plan. This does not, however, imply that there are no fees associated with a 401(k) or other qualified retirement plans, such as a Roth account. You should always read the terms of any retirement plan you are considering to ensure you understand the total cost of the plan.
The investments made with the funds you contribute to the plan determine how well a 7702 plan performs in comparison to other retirement plans. Whatever plan you choose, it is important to understand the investments in which your money is invested.