- A 7702 plan is a type of life insurance policy that has tax advantages to the insured. Due to deferment, the cash value is built over time.
- The 7702 is not a retirement fund. Instead, it is a marketing name for cash value life insurance policies.
- To be considered a 7702 and not subject the holder to taxable income, the plan must pass the cash value accumulation test (CVAT) and the guideline premium and corridor test (GPT).
When it comes to retirement plans, most people know about the 401(k) and various individual retirement accounts (IRA) available to savers. 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 understanding what 7702 plans really are and how they differ from traditional retirement funds.
What are 7702 plans?
Named for a section in the IRS Internal Revenue Code (IRC), 7702 plans aren't retirement funds at all. They 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 will be taxed.
These policies are essentially variable universal life insurance policies. Contributions to these policies grow tax-deferred over time and can be invested in different accounts. As a result, 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), IRA or savings account.
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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.
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 remain informed 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, an insurance expert at Life Benefits, says 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."
The advantages and disadvantages of 7702 plans
If 7702 plans are just life insurance policies, why would someone use them as a vehicle for retirement funds? There are certain advantages to buying a 7702 plan, like growing value on a tax-deferred basis, withdrawing funds you put into the policy tax-free in your retirement, and leaving the funds tax-free to your beneficiaries when you die. There is also no maximum contribution limit, unlike 401(k)s and IRAs. [See related article: Retirement Plan Options for Small Business Owners]
Those are attractive aspects of a 7702 plan, but there are drawbacks as well. Motivated insurance agents receive big commission checks for the sale of these policies and will sometimes misrepresent the facts. Right off the bat, 7702 plans often come with a lot of fees attached. These include things like contract fees, mortality and expense fees, administrative fees and more. 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.
According to the Cornell Law School, a 7702 must pass two tests in order for the life insurance contract to be valid: the cash value accumulation test (CVAT) and the guideline premium and corridor test (GPT). 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 he or she made a single lump-sum payment, minus any fees. To pass the GPT, the holder of the policy 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. The life insurance plans are usually a backup option to traditional plans such as a 401(k) or 403(b) and do obtain certain tax advantages.
Moreover, 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, founder and financial planner at 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 both 401(k), IRA and other retirement investing options," he added.
When putting together your financial plan, especially related to your retirement, it's important to work with a licensed advisor that 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 for the sake of their own commission.