Everything You Need to Know About 7702 Plans

What is a 7702 plan?

A 7702 plan, also called a Section 7702 plan, is a privately issued stand-alone life insurance policy. These policies may be universal, variable universal, indexed universal or whole life insurance. Notably, a 7702 plan isn’t a qualified plan, though many people who see the term “7702 plan” mistake it for this special type of tax-friendly benefit.

Additionally, a 7702 plan’s value depends on the type of life insurance policy you take out and your premium costs.

How is a 7702 plan different from a retirement plan?

7702 plans are often associated with retirement accounts, but they’re not quite the same. Because a 7702 plan is a life insurance policy, its payout goes to people other than you — namely, the beneficiaries you include on your policy.

A retirement plan, on the other hand, is accessible only to you or perhaps your spouse. You should increase its value over several decades so you can access its funds and retire from the workplace later in life. Life insurance policies go into effect only upon your death.

Taxation, penalty and insurance concerns further distinguish 7702 policies from retirement plans. We’ll explain these differences later.

How does a 7702 plan work?

A 7702 plan is structured so that its benefits and payouts are taxed fairly. This structure exists because there’s a long history of certain investment plans that are structured falsely to appear like life insurance plans. These plans then receive life insurance tax benefits despite not meeting life insurance qualifications.

To disincentivize this type of fraud, Section 7702 of the U.S. tax code gives tax benefits only to actual life insurance plans. A 7702 plan must pass two tests to receive tax benefits:

1. Cash value accumulation test: For a 7702 plan to be valid, the policyholder must not earn more money from canceling the policy than from opening it.
2. Guideline premium and corridor test: A 7702 plan cannot accept more payments from a policyholder than those needed to fund the plan adequately.

If a plan fails either of these tests, any money the plan disburses would be taxed as ordinary income instead of in the favorable ways unique to life insurance policies.

Why is there confusion about the purpose of a 7702 plan?

A 7702 plan isn’t really a retirement plan at all; it’s a life insurance policy. A clever life insurance agent or agency named the policy after Section 7702 of the U.S. tax code, which outlines the tax benefits of life insurance policies.

This code applies to policies sold after 1985. Beneficiaries of life insurance contracts sold before the implementation of this code didn’t pay income tax, and internal growth of the policy’s cash value was tax-deferred over the life of the policy.

The 7702 plans marketed today are usually just variable universal life (VUL) or cash-value life insurance policies. You can build the cash value the same way you would with mutual funds. The policy’s cash value can be invested in other accounts, which are then invested into stocks and bonds.

The 7702 code was written because many people were using life insurance policies as investments to get a generous tax break. However, a life insurance policy is supposed to serve as a death benefit to your family or beneficiaries to replace your income.

Section 7702 is a code, not a plan. If an insurance agent tries to tell you differently, meet them with skepticism. Still, this doesn’t mean a life insurance policy isn’t a good choice for retirement purposes. 

Differences between a 401(k), a 7702 plan and an IRA

There’s nothing wrong with opening a cash-value life insurance policy, but it won’t perform the same as a 401(k) or an IRA, so it isn’t a substitute.

• 401(k)s: A 401(k) plan, named for the tax code that allows employees to contribute pretax income to a specific retirement account, has been around for decades.
• IRAs: There are two IRA types: traditional IRAs and Roth IRAs. A traditional IRA lets you save money in your retirement account and allows you to use those deposits as tax deductions. With a Roth IRA, you pay taxes upfront, but withdrawals after you retire are tax-free. 

Here’s a look at how 7702 plans, 401(k)s and IRAs differ in key areas: 

Tax deductions

Depending on the retirement savings plan you choose, the money you invest in your retirement plans may be tax deductible, but the limits can change from year to year. Life insurance premiums are considered personal expenses and are not tax deductible.

• 401(k): No, but the money invested comes from pretax dollars.
• 7702: No, premiums are not tax deductible.
• IRA: Yes, invested money is tax deductible.

Penalties

If you withdraw cash from a retirement account before retirement age, you’ll likely pay a penalty. There are some exceptions, but for the most part, if you pull out money early, you’ll be taxed.

The situation with a cash-value life insurance policy is more complicated. You can withdraw cash up to your basis, which is the cash amount of your paid premiums, not including withdrawals you’ve already taken.

• 401(k): Yes, you’ll pay a penalty.
• 7702: Yes, but you can withdraw cash up to your basis.
• IRA: Yes, you’ll pay a penalty.

FDIC

The Federal Deposit Insurance Corp. (FDIC) covers deposits made to bank accounts, so your money is safe there. However, it does not insure investments because they are risky.

IRAs and 401(k) plans are generally combined and insured up to $250,000 by the FDIC. However, any money from those accounts invested in stocks, bonds or mutual funds remains uninsured.

An insurance policy is a contract, not an account, so the FDIC doesn’t protect it. Insurance companies, however, do back these contracts.

• 401(k): Yes, there’s limited FDIC protection.
• 7702: No, there’s no FDIC protection.
• IRA: Yes, there’s limited FDIC protection.

How much will a 7702 plan cost?

If you purchase a 7702 plan, which is essentially a cash-value life insurance policy, you will do two things: Pay many fees, and give an insurance agent a fat commission check.

A variable life insurance policy does offer you the chance to grow tax-deferred money; once you retire, you can withdraw funds tax-free. When you die, your beneficiaries receive the money without having to pay taxes on it.

However, there’s much more to the policy than that. What an insurance agent likely won’t tell you when they try to sell you a 7702 plan is how much it will cost you over time. Insurance contracts come with various fees. You’ll likely pay 5 to 6 percent for each deposit, much like a load for a mutual fund. [Read about the right time to hire a CPA.]

There are also ambiguous annual contract fees, mortality and expense fees, admin fees and expenses for investment options. A VUL policy could cost hundreds or thousands annually; many policies even come with early-termination fees. After all, the insurance company has to make up for the commission they paid to the agent.

Should you invest in a 7702 plan?

You have several options for long-term life insurance plans, and a cash-value life insurance policy is a legitimate choice.

One benefit of a 7702 plan is that cash accumulated within one of these policies can be used for retirement or any other need, and you can withdraw the money you deposited tax-free. The biggest benefit is that in the event of your death, your beneficiary receives the funds tax-free,  just as they would with a traditional life insurance policy.

A 7702 plan is a viable option for you if you have maxed out your annual contributions to your retirement plan, such as a 401(k), would like to plan for a more tax-free retirement income, or want to avoid making your Social Security benefits taxable due to additional income. 

Whether you invest in a 401(k), IRA or VUL policy for your retirement depends on your available funds, your needs and what you want from a retirement account. Whichever plan you choose, you should consult a licensed financial fiduciary who will work with your best interests in mind.

Sean Peek contributed to this article.