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.
Editor’s note: Need a retirement plan for your business? Fill out the below questionnaire to have our vendor partners contact you with free information.
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.
7702 plans are life insurance policies that can be leveraged for tax advantages
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.”
7702 plans are often falsely marketed as retirement funds, so it’s important to understand the difference between the two.
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.
Those are attractive aspects of a 7702 plan, but there are drawbacks as well.
If you are looking for top employee retirement plan options for your business, we can help you choose. You can learn more about some of the top options in our review of ADP and our American 401k review.
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.
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.
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.