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) plan at work and maybe you even set up an individual retirement account (IRA) with some savings to help build an even better retirement nest egg. And 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?
There's No Such Thing
It turns out that 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 from the United States Internal Revenue Code that limits tax benefits of life insurance policies. This code applies to policies sold after 1985. Beneficiaries of life insurance contracts that were sold prior to this implemented code didn't pay income tax, and internal growth of the cash value was tax-deferred over the life of the policy.
These 7702 plans that are being marketed are usually just variable or cash value life insurance policies (VUL). You can build the cash value in the same manner as mutual funds. The policy's cash value can be invested in other accounts, which are then invested in stocks and bonds. The difference between a VUL policy and whole life insurance is the cost of premiums – the VUL has variable rates while whole life has fixed premium payments.
The reason the 7702 code was written is because many were using these 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 beneficiary to replace your income. The IRC 7702 is a code, not a plan. Insurance agents who try to tell you differently should be met by you with skepticism. That doesn't mean that a life insurance policy isn't a good choice for retirement purposes though.
Differences Between a 401(k), a "7702 plan" & an IRA
There is nothing wrong with opening a cash value life insurance policy, but it doesn't perform the same as a 401(k) or an IRA, so it shouldn't be seen as a substitute. A 401(k), named for the tax code which allows employees to avoid taxes when they deposit an amount of their income into a specific retirement account, has been around for decades.
There are two types of IRA: traditional and Roth. The traditional IRA lets you save money in your retirement account and use those deposits as tax deductions. A Roth IRA has you pay taxes upfront, but when you withdraw the funds during retirement, it's tax-free. The differences between the three investment options don't make one better or worse overall.
Money that 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
7702 – No
IRA – Yes
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're going to be taxed.
It's a bit more complicated with a cash value life insurance policy. You can withdraw cash up to your basis, which is the amount of premiums you've paid in, not including any other withdrawals you've already taken.
401(k) – Yes
7702 – Yes
IRA – Yes
The Federal Deposit Insurance Corporation (FDIC) covers deposits made to bank accounts, so you know your money is safe. However, it does not insure investments because that's risky business. Money that is deposited into an account is considered insurable, though, but IRAs and 401(k)s are generally combined and insured up to $250,000 by the FDIC.
Any money from those accounts that is invested in stocks, bonds or mutual funds, though, remains uninsured. An insurance policy is a contract, not an account, and, therefore, not protected. Insurance companies, though, back these contracts.
401(k) – Yes, limited
7702 – No
IRA – Yes, limited
How Much a VUL Will Cost You
If you purchase a 7702 plan, which is essentially a cash value life insurance policy, you are going to do two things: pay a lot of fees and give an insurance agent a fat commission check. Although a variable life insurance policy offers you the chance to grow tax-deferred money within it, you can withdraw funds that you put into it tax-free once you retire, and when you die, your beneficiaries receive the money also tax-free, there's more to it.
What an insurance agent likely won't tell you when they're trying to sell you a 7702 plan is how much it's going to cost you over time. Insurance contracts come with a variety of fees. You're likely to pay somewhere around 5 to 6 percent 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 come with early termination fees. After all, the insurance company has to make up for that commission they paid to the agent.
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 what many refer to as a 7702 plan is that cash accumulated within one of these policies can be used for retirement or any other need, and money that you deposit can be withdrawn tax-free. The biggest benefit is in the event of your death, your beneficiary receives the funds tax-free – just as a life insurance policy does.
Whether you invest in a 401(k), IRA or VUL policy for your retirement depends on your money, needs and what you want out of a retirement account. Regardless of which option you choose, you should consult a financial fiduciary, who is licensed and will work in your best interest.