In the U.S., there are a slew of tax-advantaged retirement accounts that form a veritable alphabet soup of acronyms. The complexity gives room for salespeople to pitch “fake” retirement accounts to unsuspecting consumers.
"Section 7702 plans" are a prime example. Section 7702 of the Internal Revenue Service governs the taxation of life insurance policies. And it's true that some of the tax advantages within Section 7702 mimic the advantages of qualified retirement plans.
But these life insurance plans aren’t alternatives to employer-sponsored retirement plans or other qualified plans. They are a different product altogether. Here’s what you need to know about 7702 plans.
Section 7702 Plans Aren’t Retirement Accounts
"Section 7702 plan" is just a fancy term that some insurance salesmen use for a cash value life insurance policy. They are sometimes called "Section 7702 retirement plans," but these are not qualified retirement plans.
The nomenclature is a marketing moniker designed to mislead people into viewing the life insurance policy as a viable alternative to legitimate tax-advantaged retirement accounts.
Again, the 7702 “retirement plan” is not a qualified retirement account. It’s a life insurance policy — and typically an expensive one.
What Are Cash Value Life Insurance Policies?
Cash-value life insurance policies are life insurance policies with a savings component. The savings build up into cash value. The value tends to increase over time because the “cash value” held inside the policy earns interest or grows due to investment growth.
Growth in the policy account is tax-deferred. That means it's not taxed until the funds are withdrawn from the policy account.
All of these policies require policyholders to pay monthly premiums to keep the life insurance in place and build up the cash value of the policy. All the policies pay a death benefit when the policy owner dies. Over many years, the savings component of the life insurance builds up and becomes invested.
The exact investment and returns vary based on the type of insurance policy. Here are three of the most common cash value insurance policy types:
Whole Life
Typically whole life policies have a guaranteed minimum growth rate for the cash value in the policy. But they may grow somewhat faster depending on the performance of the fund. Once the cash value is adequately built up, the cash value can be used to pay the monthly premiums.
Variable Universal Life
Under a variable universal life policy, the cash value in a policy may increase or decrease depending on how the policy is invested. Policyholders may have control over how the funds are invested. The potential volatility may cause problems for people who intended to take loans from the policy to fund living expenses.
Indexed Universal Life
The cash value in indexed universal life policies is tied to a specific stock market index. In these policies, the rate of return on cash value will not dip below 0%. But the upside is limited compared with variable universal life.
Understanding Section 7702 Plans
Section 7702 of the Internal Revenue Code lays out the tax rules for “cash value” life insurance policies. Cash-value life insurance policies (also called whole life or guaranteed life policies) are first and foremost life insurance policies. If the policyholder dies, their beneficiary receives a large payout from the insurance company.
Almost all cash value life insurance policies are Section 7702-compliant. By complying with the rules in Section 7702, the cash value inside the life insurance policy can grow tax-free.
Additionally, account holders can “borrow” against the built-up cash value inside the policy, either to pay the premiums or to fund living expenses. This “tax-free loan” may be used to hoodwink unsuspecting consumers into seeing a cash value life insurance policy as a viable alternative to a retirement account.
Are 7702 Life Insurance Policies Bad?
Cash-value life insurance policies aren’t necessarily bad products. But they aren’t a great fit for the typical person. Due to high front-loaded fees and commissions, the cash value grows slowly for several years. This may explain why 20% of people allowed their whole life policy to lapse in the first three years in the most recent study by the Society of Actuaries.
Cash value life insurance policies do have tax advantages. But most people don’t have adequate income to cover all their expenses and max out their real retirement accounts. In 2021, a working person with an above-average $80,000 per year salary and a high-deductible health insurance plan for their family is eligible for all the following deductions:
- A $19,500 employee contribution to a 401(k)
- A $6,000 contribution to a Roth IRA
- A $7,200 contribution to a health savings account (HSA)
That’s $32,700 in tax-advantaged investment opportunities. When you consider other financial priorities such as paying off debt, buying a house, or saving for kids' college, a 7702 plan is unlikely to fit.
But if you’re already knocking your financial goals out of the park, and you still have strong cash flow, a cash value life insurance policy can be a useful part of estate planning. But even those who fit the bills should consult with a fiduciary financial advisor before buying any cash value life insurance policies.
Should I Cancel My Section 7702 Plan?
Cash value life insurance policies aren't typically the best purchase initially. But it's important to understand that the fees are usually front-loaded. So an older life insurance policy may be valuable if you can afford to pay the premiums.
This post from CFP Michael Kitces helps explain scenarios where keeping the policy in place could make sense. Again, you may want to work directly with a CFP to help you analyze whether to keep the policy.
Final Thoughts
Overall, Section 7702 plans are legitimate life insurance products. And they have a place in certain financial plans.
But profiteers may try to sell you a high-cost policy even if it isn't the right fit. Ultimately, it's up to you to learn about these plans and carefully consider their advantages and drawbacks before you buy a policy you don’t need.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.
