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Everything You Need to Know About 7702 Plans

Max Freedman
Max Freedman
business.com Contributing Writer
Updated Jun 27, 2022

A 7702 plan isn't really a retirement plan at all – it's a life insurance policy.

You’ve been responsible with your money by investing in your 401(k) retirement plan at work. Maybe you have even set up an individual retirement account (IRA) with some savings to build an even better retirement nest egg.

Then a financial agent tries to sell you a 7702 plan. It sounds great: a high rate of return, little to no risk, and no penalties for withdrawing money. Why didn’t your financial advisor tell you about this before? And why isn’t everyone pouring their money into a 7702 plan?

What is a 7702 plan?

A 7702 plan, also called a Section 7702 plan, is a privately issued standalone 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 what type of life insurance policy you take out and how much your premiums cost.

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. Since 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 only kick in upon your death.

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

TipTip: If you’re self-employed, consider a Simplified Employee Pension (SEP) IRA, which allows you to make tax-deferred contributions.

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 even though they do not meet life insurance qualifications.

To disincentivize this type of fraud, Section 7702 of the IRS Tax Code gives tax benefits only to actual life insurance plans.

A 7702 plan must pass two tests to receive taxation 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?

As we explained, 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 IRS 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 being marketed today are usually just variable universal life (VUL) or cash-value life insurance policies. You can build the cash value in the same manner as you would mutual funds. The policy’s cash value can be invested in other accounts, which are then invested in stocks and bonds.

Did you know?Did you know? The difference between a VUL policy and whole life insurance is the premium cost: A VUL policy has variable rates, while whole life has fixed premium payments.

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

IRC 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 that policy won’t perform in the same way as a 401(k) or an IRA, so it isn’t a substitute.

A 401(k) plan, named for the tax code that allows employees to avoid taxes when they deposit a portion of their income into a specific retirement account, has been around for decades.

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 some differences between 7702 plans and traditional retirement plans.

Tax deductions

The money you invest in your retirement plans is 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): Yes, invested money is tax-deductible.
  • 7702: No, premiums are not tax-deductible.
  • IRA: Yes, invested money is tax-deductible.

Penalties

If you withdraw cash from a retirement account before you reach 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.

FYIFYI: If you’re considering borrowing from your 401(k) plan, you should understand that the money used to pay the interest on the loan from the account is taxed twice.

FDIC

The Federal Deposit Insurance Corporation covers deposits made to bank accounts, so you know your money is safe. However, it does not insure investments, because that’s risky business.

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 VUL cost?

If you purchase a 7702 plan, which is essentially a cash-value life insurance policy, you will do two things: pay a lot of 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, and 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’re trying to sell you a 7702 plan is how much the plan will cost you over time. Insurance contracts come with a variety of fees. You’re likely to pay somewhere around 5% to 6% for each deposit you make, much like a load for a mutual fund.

There are also ambiguous annual contract fees, mortality and expense (M&E) fees, admin fees, and expenses for investment options. A VUL policy could cost you hundreds or thousands each year, and many even come with early termination fees. After all, the insurance company has to make up for the commission they paid to the agent.

TipTip: If you’re a business owner looking for retirement plans for your employee benefits package, read our reviews of the best business retirement plans to compare fees and plan options.

Should you invest in variable universal insurance?

You have several options when looking at 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.

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 out of a retirement account. Whichever plan you choose, you should consult a licensed financial fiduciary who will work with your best interest in mind.

Image Credit:

Solis Images / Shutterstock

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.