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What Are 7702 Plans and How Can They Be Used for Retirement?

Max Freedman
Max Freedman
business.com Contributing Writer
Updated Feb 14, 2022

These life insurance policies are tax-deferred to build cash value.

When it comes to retirement plans, most people know about 401(k) plans and various individual retirement accounts (IRAs). What many haven’t heard of, though, are 7702 plans. Marketed as vehicles to withdraw funds without incurring tax penalties, 7702 plans sound like a flexible retirement fund. So why aren’t they more widely used?

The answer lies in what 7702 plans really are and how they differ from traditional retirement funds.

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What are 7702 plans?

Named for a section in the Internal Revenue Code (IRC), 7702 plans are life insurance policies that can be leveraged for certain tax advantages. Under Section 7702 of the IRC, the federal government lays out the parameters by which life insurance policies that build cash value are taxed.

These policies are essentially variable universal life insurance policies. Contributions to these policies grow tax-deferred and can be invested in different accounts. They do not have age restrictions on withdrawals. However, 7702 plans are not retirement funds and should not be viewed as a replacement for a 401(k) retirement account, IRA or savings account.

Bottom LineBottom line: 7702 plans are life insurance policies that can be leveraged for tax advantages

What are the differences between 7702 plans and retirement funds?

A life insurance policy, such as a 7702 plan, is a contract between you and the company selling the policy, for which you pay premiums. While these life insurance policies grow tax-deferred, they do not offer a tax deduction like retirement funds do.

If that’s the case, why are 7702 plans often marketed as retirement funds? Simply put, it makes them easier to sell. Insurance agents and brokers are often motivated by large commissions, and some are willing to misrepresent the facts to close a deal. The best way to protect yourself from these distortions of reality is to educate yourself about what a 7702 plan actually is. There are ways to use these policies to your advantage, but they are not retirement accounts.

Thomas P. McFie, insurance expert at Life Benefits, said that 7702 plans should not be seen as an alternative to qualified retirement plans, “but as a way to greatly enhance any retirement, estate or charitable giving planning already being implemented or considered.”

Did you know?Did you know? 7702 plans are often falsely marketed as retirement funds, so it’s important to understand the difference between the two.

What are the advantages and disadvantages of 7702 plans?

If 7702 plans are just life insurance policies, why would someone use one as a vehicle for retirement funds? There are certain advantages to buying a 7702 plan.

  • Growing value on a tax-deferred basis: As the investments comprising your 7702 plan grow in value, you don’t have to pay taxes on your earnings.
  • Withdrawing funds you put into the policy tax-free in your retirement: You can borrow against your 7702 plan in retirement without paying any taxes. This tax advantage distinguishes 7702 plans from IRAs and 401(k) plans, many of which require you to pay taxes when you withdraw funds.
  • Leaving the funds tax-free to your beneficiaries when you die: This scenario results in a tax advantage as opposed to leaving your estate to a beneficiary through a will. 
  • No maximum contribution limit: This characteristic of 7702 plans is also unlike 401(k) plans and IRAs. 

Those are attractive aspects of a 7702 plan, but there are drawbacks as well.

  • Lack of transparency regarding plan conditions: Motivated insurance agents receive big commissions on the sale of these policies and will sometimes misrepresent the facts.

  • Substantial fees: Right off the bat, 7702 plans often have a lot of fees attached, such as contract fees, mortality and expense fees, and administrative fees. There is also usually a high cancellation fee to get out of the contract, which is often pushed by a salesperson who gets a generous commission for selling it.

  • Interest on plan withdrawals: Although you can withdraw funds from your 7702 plan tax-free, you’re technically taking out a loan to do so. That’s because you’re borrowing money from your plan, not withdrawing your own money as you would with retirement plan funds. As such, you’ll have to pay interest on your 7702 withdrawals.

  • No tax deduction: Up to a certain limit, money that you contribute to a 401(k) or IRA is tax deductible. This rule applies to any employer-matching funds a business contributes to its employees’ retirement plans. It also applies to any money a person adds to their personal retirement plan, with an especially high limit for SEP IRAs. However, it does not apply to 7702 plans.

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7702 plan validity tests

According to Section 7702 of the U.S. Tax Code, a 7702 must pass two tests in order for the life insurance contract to be valid.

  • The cash value accumulation test (CVAT): As part of the CVAT, the contract must stipulate that the cash value for surrendering must not exceed what the holder would have paid if they made a single lump-sum payment, minus any fees.
  • The guideline premium and corridor test (GPT): To pass the GPT, the policyholder must not have paid more than necessary to fund the insurance benefits included.

If the 7702 doesn’t pass these two tests, then the income from the 7702 is considered taxable by the government. Even if the 7702 passes both tests, it doesn’t mean it constitutes a true retirement plan. However, the cash value of the policy can be used for retirement purposes. A life insurance plan is usually a backup option to a traditional plan such as a 401(k) or 403(b), and therefore has certain tax advantages.

What else should you know about 7702 plans?

Unlike traditional retirement accounts, variable universal life insurance policies are not backed by the Federal Deposit Insurance Corporation. That means the funds directed toward your policy are not protected, although the contracts are backed by the insurance company.

“Life insurance is very important to a person’s financial plan but is a poor investment vehicle,” said Joshua Escalante Troesh, financial planner and founder of Purposeful Strategic Partners. “While life insurance grows tax-deferred, you do not get a tax deduction for contributions. Further, you can’t take the money out tax-free unless you take loans against the policy, which has its own risks. A person should only look at possibly using these plans once they have maxed out 401(k), IRA and other retirement investing options.”

When you’re putting together your financial plan, especially in relation to your retirement, it’s important to work with a licensed advisor who has a fiduciary responsibility to you as a client. You can be sure their recommendation is in your best interest and that they aren’t trying to sell you a product just to earn a large commission.

Business.com editorial staff contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.

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Prostock-Studio / Getty Images

Max Freedman
Max Freedman
business.com Contributing Writer
Max Freedman is a content writer who has written hundreds of articles about small business strategy and operations, with a focus on finance and HR topics. He's also published articles on payroll, small business funding, and content marketing. In addition to covering these business fundamentals, Max also writes about improving company culture, optimizing business social media pages, and choosing appropriate organizational structures for small businesses.