7702 Plans vs. 401(k)s [Top Pros and Cons of Each]

Comparing IRC 7702 vs 401k and 529 plans

Which of these vehicles – if any – belong in your financial plan?

When it comes to retirement planning, many people are familiar with the more “traditional” avenues, like employer-sponsored 401(k) plans and Individual Retirement Accounts, or IRAs. But there are some additional options that a lot of investors and retirees are not aware of, even though they have been used for over 100 years…and they could provide some significant tax benefits and guarantees. One of these is the IRC 7702 plan.

What is an IRC Section 7702 Plan and How Does It Work?

Named for a section of the Internal Revenue Code (IRC), the 7702 plan is a specific type of cash value life insurance policy that can be leveraged for various tax advantages – including supplementing your retirement income with tax-free funds.

In many ways, 7702 plans work the same as other permanent life insurance policies. For instance, they are life insurance contracts between a policyholder and the offering insurance company – and, provided that the plans meet certain regulations listed in the tax code, a portion of the premiums paid into a 7702 plan go towards building up cash savings while another portion goes towards the cost of the insurance coverage (i.e., the death benefit).

But, while most people consider purchasing life insurance for the death benefit proceeds it can provide for debt payoff and income replacement, the reality is that these flexible financial tools can be used for so much more – even when the insured is still alive.

Different types of cash value life insurance:

• Whole life insurance
• Universal life insurance
• Indexed universal life insurance
• Variable universal life insurance

Each of these life insurance types use different parameters for how the return in their cash value components are determined. But all allow for the funds in the plan to grow on a tax deferred basis. This means that there is no tax on the gain unless or until the money is withdrawn.

IRA Conversion Strategies with Indexed Universal Life Insurance

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How 7702 Plans Differ from Traditional Retirement Accounts

If your employer offers a traditional 401(k) plan, you have the opportunity to build up a nice nest egg, as well as take advantage of tax-related benefits like pre-tax contributions and tax deferred growth.

For instance, the money that you contribute – up to the annual maximum amount – is not considered taxable income in the year(s) that you contribute. Therefore, with a reduced income base, you can either pay less in income taxes or receive a larger income tax refund during these years.

In addition, because the funds in the traditional 401(k) plan grow tax deferred, you won’t have to pay taxes on the growth until you withdraw the gains. This, in turn, could allow your account value to grow exponentially because you are generating a return on your:

• Contributions
• Previous gains, and
• Funds that would have otherwise been paid in taxes

Traditional 401(k) plans may allow you to do some other things, too, such as:

• Choosing from a variety of different investments (like mutual funds, bonds, and money market accounts)
• Borrow money from the account (although interest will be charged on the borrowed funds)
• Take penalty-free withdrawals for certain types of emergencies

Depending on the company that offers the traditional 401(k) plan, you may also receive “matching” contributions from your employer. The amount of the match is typically determined as a percentage of what you contribute in a given year.

Because many 401(k) plan participants invest at least some of their funds in equities (such as stocks and mutual funds), there is a risk of loss. This could include the erasing of previous gains, as well as losing some (or all) of your contributions.

Many investment advisors tout “average” returns when trying to entice investors to move money into various financial vehicles. But even if a particular investment generates a good average return, you could still come up short.

Take, for instance, contributing $1,000 into an account, generating a 0% (a seemingly “break even”) average return over a 10-year period, but still losing a portion of what you contributed. In fact, any time there is a negative return that is factored into the overall mix, the average return will not equal the actual return on your money.

With that in mind, even though many investors take full advantage of the benefits offered through traditional 401(k) plans, there are some “tradeoffs” to be aware of that may impact how you move forward, as well as the amount of money that you will actually have available to spend when you make withdrawals.

401 (k) Drawbacks:

The following are 4 potential hazards to consider when using a 401 (k) plan.

1. Maximum annual contribution limits.

Participants in traditional 401(k) plans are only allowed to contribute up to a certain amount each year. In 2022, if you are age 49 or younger, the most you can put into an employer-sponsored 401(k) is $20,500. If you are age 50 or older, you can add an additional $6,500 in “catch up” contributions, for a total of $27,000. In 2023, these figures will rise to $22,500 and $30,000 respectively. So, what happens in you wish to contribute more so you can obtain more tax-advantaged growth? The 7702 plan can help!

2. Required minimum distribution (RMD) rules.

When a traditional 401(k) plan participant turns 72, they are required to start withdrawing at least a certain amount from the account every year going forward. If they don’t, they will face a financial penalty from the IRS.

3. IRS early withdrawal penalty.

Conversely, if you withdraw funds before turning 59 ½, you could incur a 10% “early withdrawal” penalty from the IRS. This is in addition to any taxes that you owe.

4. Withdrawals are usually 100% taxable.

Another significant drawback to traditional 401(k)s is that 401 (k) withdrawals are usually 100% taxable. Because you are allowed to contribute money on a pre-tax basis, and the funds in the account grow tax deferred, Uncle Sam will eventually want HIS money – and he would much rather generate tax from an account that has grown substantially over time versus the much smaller contributions that go into the account.

This taxation on withdrawals can actually create a double whammy, as many economists expect income tax rates in the U.S. to rise in the near future…and no one knows how high they will go. But in the past, the top federal income tax rate has been in excess of 90% several times.

So, the more income tax you owe, the less net spendable income you will have available for paying your expenses in retirement.

Top Federal Income Tax Rates 1913 – 2022

Tax Dominoes

Like a row of dominoes, more taxable income in retirement can affect other cash flow sources, too. For instance, many retirees do not know that up to 85% of their Social Security retirement income benefits could be taxable.

How much these benefits are taxed depends in large part on how much taxable income you generate from other sources – such as a traditional 401(k) plan – as well as when you claim your Social Security benefits.

Based on your situation, you may have to pay tax on a percent of your Social Security benefits (in 2022), if you meet one of the following criteria:

• You file your federal income tax return as an individual taxpayer, and your combined income is:
• Between $25,000 and $34,000 (if so, up to 50% of your Social Security retirement benefits could be taxable)
• More than $34,000 (if this is the case, up to 85% of your Social Security benefits may be taxable)
• You file a joint income tax return with your spouse, and you have a combined income that is:
• Between $32,000 and $44,000 (if so, then up to 50% of your benefits may be taxable)
• More than $44,000 (in this case, up to 85% of your Social Security retirement income benefits may be taxable)
• You are married and you file a separate tax return.

Note that the amount of your combined income is equal to your adjusted gross income plus any non-taxable interest earned, plus one-half of your Social Security benefits.

In addition, the IRS requires you to start withdrawing at least a minimum amount of money from traditional 401(k)s once you turn 72 – and if you don’t follow these required minimum distribution rules, you can be penalized.

Traditional 401(k) Pros and Cons

Contrast this with a 7702 Plan

This is where the 7702 plan can provide you with some significant benefits – including the ability to access funds tax free from the policy’s cash value component. Depending on the then-current income tax rates, this feature alone could allow you to put much more money towards your living expenses in the future.

Policyholders can usually access cash from permanent life insurance plans. One way is through withdrawals. But, similar to with the traditional IRA, when the tax deferred gains are accessed via withdrawals, they will be taxable.

Another option for accessing cash from a cash value life insurance policy is through a loan. Although some people are uncomfortable with borrowing money, a life insurance loan could provide several enticing benefits.

Life Insurance Loans Are Not Taxable

For instance, life insurance loans are not taxable. Therefore, you will be able to use 100% of the funds from the loan for whatever you need or want. Plus, these loans are actually from the insurance company, and they simply use the cash in your policy as collateral (versus borrowing directly from the cash value). Because of that, 100% of your cash value funds will still be generating interest.

As an example, if you have $80,000 of cash value in a whole life insurance policy, and you borrow $40,000, interest will continue to be generated on $80,000.

As an added bonus, even though the insurer will charge interest on the loan, if the funds are not fully repaid at the time of the insured’s passing, the remaining balance of the loan will be paid off using the death benefit proceeds (with the remainder of the money then going to the beneficiary).

Life Insurance Gains are Tax Deferred

Similar to traditional 401(k) plans, the funds that are in a 7702 plan grow tax deferred. So, the build-up of account value can snowball – especially over time. If the policy is structured properly, there are ways to enhance the growth of the cash value in a 7702 plan even more.

For instance, a paid up additions rider is a mechanism that is used to put additional dollars into a dividend paying whole life insurance policy in order to increase the performance of the cash value. In this case, every dollar of premium that is allocated to the paid up additions rider creates a small “paid up” insurance policy that has its own cash value that is created right away.

With that in mind, a whole life insurance policy that has a substantial portion of its total premium payment allocated to paid up additions will usually outperform those that do not take advantage of paid up additions.

Additional 7702 Plan Benefits

• No maximum annual contribution limits
• No required minimum distribution (RMD) rules
• Tax-free policy loans have no impact on the taxability of your Social Security retirement income benefits
• Protection from creditors and bankruptcy (in some states)
• Self-completion (i.e., if the insured dies, the death benefit proceeds are received income tax free by the beneficiary, and they can be used for their originally intended purpose and/or other needs and wants)

Because certain cash value life insurance policies protect principal in any type of market or economic environment, you generate a nice profit over time – and without worry about what is happening with the stock market. With whole life insurance you have a non-correlated asset and with index universal life you have a 0-1% floor to protect against market losses.

2% Compound Return, Tax-Deferred for 10 Years

Given the many advantages of 7702 plans, there are a few potential drawbacks to be mindful of, such as:

• No income tax deduction for contributions
• The cash value might initially build up slowly
• Surrender penalties on withdrawals in the early years of the policy
• Gains that are withdrawn are taxable
• The insured must qualify for the life insurance coverage

Because not all life insurance policies are the same, it is essential to work with a professional who is well-versed on how a cash value life insurance policy could be used to supplement your retirement plan.

So, before you make a long-term commitment to a plan – which could cost a significant amount in surrender charges if you later cancel the policy – it is recommended that you contact an expert in this area who can narrow down which plan, if any, is right for you.

Pros and Cons of 7702 Plans

Benefits of 7702 Plans – Both Before and After Retirement

In addition to accessing tax-free retirement income, there are other areas where the 7702 plan can also be beneficial, such as college funding. The cost of a college education can be daunting, so it is important to start as early as possible when saving for this expense.

529 Plans

Many families opt to use a 529 plan when saving money for a child, grandchild, or other loved ones’ future college costs. These are state-run plans where you can invest in a selection of mutual funds.

The earnings in the account grow tax deferred, and provided that the withdrawals are used for education-related expenses, they are tax free. Depending on the state, you could also receive a tax deduction or credit for contributions to a 529 plan.

529 Plan Disadvantages

Although 529’s are popular college savings plans, though, they have a couple of drawbacks. First, because the money is often invested in equities like mutual funds, there is the chance that prior gains and contributions could be lost if the market or investment turns south.

In addition, if the donor / contributor to a 529 plan suddenly passes away, there is no guarantee that enough funds will be available for the beneficiary when he or she is ready to go to college.

That’s why a strategy for college savings (or to supplement savings for college) is to purchase a cash value life insurance policy. These policies offer a cash value component that grows tax deferred. Money may also be accessed tax free through a policy loan.

Cash Value Life Insurance vs. 529 Plans for College Saving & Funding

Cash Value Can Be Used for Anything

But unlike the 529 plan, there is no requirement that the life insurance cash value be used for college-related costs. In fact, the money that is either borrowed or withdrawn from a cash value life insurance policy can be used for anything. Therefore, if the potential student decides not to attend college in the future, there are no “penalties” when accessing the life insurance cash value.

Further, the cash value of whole life and indexed universal life insurance policies won’t be reduced – even in the event of a stock market correction. So, because the principal – and the previous gains – are all locked in, there is no concern about the account losing value in the future.

Unlike a 529 plan, life insurance won’t impact any financial aid that the student may be applying for. This is because the cash surrender value is not considered as an eligible asset when determining the expected family contribution for need-based financial aid when submitting the federal government’s form, Free Application for Federal Student Aid, or FAFSA.

A cash Value life insurance policy is also considered to be a self-completing plan. This means that if the insured passes away – even if they have only made one premium payment into the policy – the beneficiary will receive the tax free death benefit. Therefore, the insured individual can make sure that even if the unexpected is to occur, the beneficiary will still have the money that they need for their future education costs.

7702 vs. 529 College Savings Plan

Are You a Good Candidate for a 7702 Plan?

While IRC 7702 plans can offer many enticing benefits, they are not suitable for everyone. However, a 7702 plan may be a good option if you:

• Are seeking more tax free income in retirement
• Have “maxed out” the annual contributions to your 401(k) and/or other qualified retirement plan(s) and want additional tax advantaged growth
• Would like principal protection in any type of stock market environment
• Want to use certain benefits while living
• Do not want to make up for losses before generating gains again
• Want the assurance of the death benefit so that finances are still covered – even in the event of the unexpected
• Do not want additional income that could cause your Social Security benefits to be taxable
• Don’t want to be forced to withdraw money at age 72 (nor be penalized if you don’t do so)

How to Find the Best 7702 Plan

Although 7702 plans can be a nice compliment to your other retirement savings, these vehicles should not be used to completely replace them. Rather, it is recommended that you look at your overall financial picture – including short- and long-term objectives, potential tax situation, and other retirement income generators – and from there design a plan that works for you.

At Insurance and Estates, we focus on assisting consumers with protecting what they have worked for, while at the same time helping them to reduce – or even eliminate – taxable income and withdrawals in retirement.

So, if you would like to set up a time to talk with one of our Insurance and Estates specialists, feel free to call us directly at (877) 787-7558 or send us an email via our secure online contact form by going to info@insuranceandestates.com. We look forward to helping you reach your retirement goals.