For those of you that are familiar with the Internal Revenue Code (IRC), or happen to know a little about the tax advantages of life insurance contracts, you probably know that IRC section 7702 defines the type of life insurance contract that receives tax advantages. A “7702 Plan” or “7702 Private Plan” in common terms is known as cash value life insurance.
When you pay premiums on these cash value policies, you pay insurance premiums with after-tax dollars. As a result, the cash value in the policy grows tax-deferred. In this way they are similar to a Roth IRA, but of course without the qualified account limits and restrictions we talked about in our article 401k withdrawals and loans.
In the following article, we will attempt to point out 7702 life insurance pros and cons. Although not exhaustive, we have attempted to cover everything related to 7702 life insurance, as well as the 702j Retirement Plan. However, you will notice quite a few links in this guide. Each link will bring you to another article we have written and are offered to give you further guidance.
So now, the question that often arises when talking about 7702 plans pros and cons is…
Aren’t all life insurance policies tax-advantaged?
No, not all life insurance policies are tax-advantaged. While typically the life insurance death benefit is not taxable, we have to differentiate between tax advantaged and non tax advantaged policies. And that is the reason the IRC had to define which policies were tax advantaged in IRC 7702, the section of the code that helped originate the 702(j) retirement plan that we will address below.
So back to our question, are all life insurance policies tax advantaged. Currently about 37% of all new life insurance policies are term. Term life insurance policies provide a death benefit and nothing more. They are cheap. They provide safety. But they do not provide any cash value.
As a result, there isn’t a taxable event that is to be considered. The exception would be the term life insurance death benefit – but of course all life insurance death benefits are paid tax free.
Another policy that is not tax advantaged is any policy that would come under the umbrella of IRC section 7702 A. But before we get there, let’s start with some basic definitions.
The IRC clearly defines cash value life insurance policies in section 7702.
Section 7702 of the United States Internal Revenue Code defines a life insurance contract. The code reads as follows:
26 U.S. Code 7702 – Life insurance contract defined
(a) General rule For purposes of this title, the term “life insurance contract” means any contract which is a life insurance contract under the applicable law, but only if such contract—
(1) meets the cash value accumulation test of subsection (b), or
(2) (A) meets the guideline premium requirements of subsection (c), and
(B) falls within the cash value corridor of subsection (d).
Cash Value Accumulation Test vs Guideline Premium and Corridor Test
and In order to maintain the tax advantages allotted to life insurance under IRC Section 7702, the two different tests require a minimum amount of death benefit protection relative to the policy’s cash value.
Either the Cash Value Accumulation Test (CVAT) or the Guideline Premium and Corridor Test (GPCT) must be chosen upon policy issue. Further, with either test, the “7-Pay” test criteria must be met or the policy will become a Modified Endowment Contract (MEC).
Which is why section 7702 is followed by 26 U.S. Code § 7702A – Modified endowment contract defined. The good news is that your life insurance company will closely monitor your policy to help protect you from over-funding the policy and creating a MEC.
IRC Section 7702 is very important for two reasons.
- The fact that the IRC includes cash value life insurance policies means that they are currently favored in the tax law.
- In order to maintain favored status, you must be aware of the definition outlined in IRC section 7702.
The fact that the law guarantees tax advantages for your 7702 life insurance policy is something that might make you sleep well at night. It’s true that the laws can change, and in fact they have changed in the recent past. But when they do change, those that had policies in place prior to the change are generally allowed to enjoy the benefits they had prior to the law change.
The specific details of section 7702 are actually pretty challenging to decipher. But we’ve done our best to explain the specifics in our article about Modified Endowment Contracts. Just keep in mind that there are limits to how much money you can contribute per year, based on the total death benefit of the policy. Your life insurance carrier will help monitor your contributions and alert you if you are in danger of exceeding the limits.
702(j) Benefits – Tax Advantages in Retirement
Life insurance has amazing tax benefits for you in retirement, including the fact that it does not have a required minimum distribution amount, which makes it superior to 401ks and IRAs in this regard.
- 401k plans and IRA plans require (i.e. you have no choice) you to take out required minimum distributions (RMDs), which are taxed as ordinary income, i.e. based on your income tax bracket. The result is that your social security benefits may be taxed and Medicare part B premium penalties may apply.
The 7702 Plan or 7702j Retirement Plan
Is a 7702 really a “plan” or is it just tax code?
It’s possible you’ve heard the phrase “7702 plan,” “7702j retirement plan” or “7702 Private Plan” for retirement. In fact, you may have heard people criticizing these “plans” for not really being a “plan” at all, but rather overfunded life insurance.
In our opinion, a better way to market life insurance under 7702 would be to simply call it a life insurance retirement plan or LIRP. But essentially, when you see an advertisement for a 7702 Plan or 7702j retirement plan, know that it is cash value permanent coverage they our touting.
7702 plan vs. 401k plan
Those that are promoting cash value life insurance will sometimes try to market it as a retirement plan by comparing it to 401k plans. However, a 401k plan is a scam designed to take your more valuable dollars and give less valuable dollars back to you down the road.
Those that are critical of life insurance, typically financial advisors who are pushing 401ks or mutual funds, will be quick to say that a 7702 plan isn’t really a “plan” in the same sense as a 401k is a plan.
Well, that’s true to some degree, it’s just a section of the tax code.
However, it would seem that if someone says that they have a “plan” for using their cash value life insurance to save for the future…well, that would probably be be a plan. And, I don’t know how you can say that isn’t a “plan.” A 401k is also just a section of the tax code, and yet most consider it a “plan.”
But to be more specific, there are some key differences between the 7702 and the 401k “plans.”
When examining the 7702 plan pros and cons vs the 401k, one major pro is that life insurance is a contract between the company and the policy holder. There isn’t a third party involved, i.e. no middle man.
Another 7702 plan pro is the tax advantages. The money you pay into your policy grows tax-deferred and experiences true compound growth.
Further, the cash value in your policy can be accessed tax free through life insurance policy loans.
Additionally, if you use whole life insurance to fund your 7702 retirement plan, you are using a non correlated asset. Saying whole life insurance is a non correlated asset is simply saying that whole life insurance is not tied to the stock market. And that is a good thing since it allows diversification and avoids potential stock market crashes that could be looming in the not so distant future.
And finally, unlike a 401k or IRA, your life insurance policy also has a death benefit that is paid to your beneficiary tax free.
And be aware of one con of a 401k plan is that it requires a custodian, or middle man, to handle your funds on your behalf.
Another con of a 401k plan vs 7702 plan is the 401k has no death benefit and therefore there is no additional money going to your beneficiary when you die.
Finally, the 401k proceeds paid to your beneficiary will most likely be taxed. In contrast, under a 7702 retirement plan, the proceeds paid to your beneficiary are not taxed against your estate or against your beneficiary as income.
In these ways the two “plans” are different. But for those that want to create a “plan” for some sort of long term savings vehicle, you can use the term “plan” to describe both cash value life insurance and 401k.
How does a 7702j retirement income plan work?
Using cash value life insurance to save for retirement, or even to purchase other assets with your policy’s cash value, is something that has been done for decades with great success.There are many benefits in choosing life insurance to plan your retirement, especially when you follow the infinite banking concept.
Term life vs Whole life
When you pay premiums on a cash value life insurance policy, a portion of the premium goes toward the cash value and the rest goes to cover the cost of insurance (remember, you are paying for a death benefit).
For those that are critical of these policies, they are quick to point out term is cheaper and that these policies don’t accrue much cash value in the early years. For those that try to compare these as apples to apples (term life vs. whole life) there is some merit to the criticism if you are just comparing the death benefit costs.
But the reality is that they are NOT apples to apples. Term life is inexpensive and provides a specific solution to specific needs, but it is not the same as cash value life insurance (whole life). Term life has its place in a comprehensive estate plan, especially if you are younger and need a large death benefit.
There are plenty of people that want the tax advantages of whole life policies, and also want the safety and security whole life offers outside of the volatile stock market. For those that plan properly, they can purchase a very small amount of whole life, and use paid-up additions to grow the cash value very quickly (as early as the first year), AND they can use term insurance (preferably as a policy rider) to supplement their overall family protection along the way.
Before moving on, we need to take a moment here and point out one thing about section 7702B and how it relates to cash value life insurance under 7702.
IRC Section 7702B Treatment of qualified long-term care insurance
Under 7702B of the internal revenue code, the IRS lays out the various rules of long term care insurance. One section of particular note is 7702B(e)(1) which allows life insurance to include long-term care insurance riders and maintain the LTC insurance tax benefits.
This is important solely for those looking to use life insurance as part of a retirement plan and are concerned about long term care costs. Rather than having to buy an individual long term care insurance policy, as of 2009 you can buy life insurance with a long term care rider instead, opening the market up to more LTC retirement planning options.
Now back to Section 7702 where we will now answer the question,
What is a 770 or 702j retirement plan?
The short answer is that the 770 account and the 702j account are both marketing ploys.
The 702 j retirement plan hoax is used to create mystery and interest in a subscription based newsletter. Seen together, it’s obvious these two terms were taken from the 7702 plan discussed above.
Tom Dyson, in his Palm Beach Newsletter created quite the stir when he sent out emails trying to persuade people to “subscribe” so they could find out more about this “Secret Investment Account” AKA, “President Reagan’s Secret 702(j) Retirement Plan.”
He presented the 770 and the 702j as a special account that could earn significantly more than the banks and other financial institutions.
Ultimately, for those that did subscribe, they found out that he was talking about cash value life insurance. The same insurance that is required by section 7702 of the IRC to maintain tax advantaged status.
What is really interesting is the IRC section that he points to, 7702j.
IRC 7702 (j) is for certain church self-funded death benefit plans treated as life insurance that pertain to a plan or arrangement provided by a church for the benefit of its employees and their beneficiaries, directly or through an organization.
What exactly was going on here? Was he trying to advise people to set up their own “church” in order to take advantage of a benefit in the tax code regarding church self-funded death benefits or retirement income?
Whatever the case, the bottom line is that 770 and 702j “plans” are simply marketing gimmicks. These so called “plans” are nothing new. Neither are they a secret.