Understanding Section 7702 Plans | Bankrate

IRS Section 7702 was created to help define if a life insurance policy qualifies for favorable tax treatment. When a life insurance policy meets the IRS’s 7702 requirements, the payout is exempt from income tax. If a policy can’t meet the criteria, however, you will likely be hit with a tax bill because your plan doesn’t qualify for tax-advantaged status. Bankrate is here to walk you through how these tax rules influence not only taxation but also overall benefits and cash value.

What is Section 7702?

While often referred to as a “7702 plan,” this term is more of a marketing concept rather than an actual insurance policy type. Section 7702 of the IRS tax code defines the criteria that cash value life insurance policies must meet to qualify for tax advantages. There are two main types of life insurance: term life insurance and permanent life insurance. Only permanent life insurance policies, such as whole life and universal life, can accumulate cash value. Section 7702 applies specifically to these cash value policies.

The tax code sets out multiple tests that these policies must pass to retain their tax-advantaged status:

1. Cash Value Accumulation Test (CVAT): This test ensures that the cash surrender value of the policy does not exceed the amount needed to fund future benefits. In simpler terms, the cash value of the policy must stay within limits set by the IRS.
2. Guideline Premium and Corridor Test (GPT): This is a two-part test. The guideline premium test ensures that the total premiums paid do not exceed the maximum amount allowed for the policy to qualify as life insurance. The corridor test requires that the death benefit is sufficiently higher than the cash value to meet IRS guidelines.

To help you better understand these two tests, essentially:

• The CVAT ensures that the amount of cash you could get from canceling the policy isn’t more than what you would need to pay for the policy’s future benefits upfront.
• The GPT makes sure you haven’t paid more into the policy than necessary and that the death benefit is always significantly higher than the policy’s cash value.

If a life insurance policy does not meet these criteria, its proceeds may be taxed as ordinary income. Understanding Section 7702 helps policyholders know how their policy’s cash value can grow and what tax advantages might be available. While these policies are not retirement plans, policyholders can typically borrow against the cash value or make withdrawals for various purposes, including retirement. However, it’s important to understand the rules and potential tax implications of such withdrawals.

What is a cash value accumulation test (CVAT)?

The CVAT is one of the tests defined in Section 7702. This test ensures that the cash value of a life insurance policy does not exceed the net single premium required to buy the policy outright, based on its death benefit. In other words, the cash value shouldn’t be higher than what you would have paid in a lump sum to purchase the policy, excluding any fees, if you want to maintain its tax status. If a policy passes the CVAT, it qualifies as life insurance for income tax purposes.

For example, if you have a whole life insurance policy, the CVAT makes sure that the cash value you could receive if you canceled the policy is not more than the single payment you would need to buy the policy upfront. Policies that typically use the CVAT include whole life insurance. These policies accumulate cash value over time, and the CVAT ensures this cash value remains within the limits set by the IRS. By meeting this test, policyholders can benefit from the tax advantages associated with genuine life insurance policies.

What is a guideline premium and corridor test (GPT)?

The GPT is a two-part test defined in Section 7702 to determine if a life insurance policy qualifies for tax advantages.

• Guideline premium test: This part of the test limits the amount of premiums that can be paid into the policy at any given time. The limit can vary based on the insurance company’s expenses and claims experience. Essentially, it ensures that the policyholder doesn’t pay more into the policy than necessary for it to be considered life insurance.
• Corridor test: This part of the test requires that the policy’s death benefit always exceeds a specified multiple of its cash value. This multiple can vary based on the insured individual’s age. If the cash value exceeds this corridor, the policy is determined to be overfunded and is classified as a Modified Endowment Contract (MEC), which loses the tax benefits associated with life insurance.

To remove the jargon and simplify these concepts further:

• The guideline premium test makes sure you don’t put too much money into the policy at once. The limit depends on the insurance company’s costs and experience.
• The corridor test ensures that the death benefit is always much higher than the cash value of the policy. This multiple varies with age. If the cash value gets too high, the policy is considered overfunded and loses its tax benefits.
• The corridor narrows as you get older, which allows for the policies to endow at maturity.

Policies that often use the GPT include universal life insurance. These policies allow for flexible premiums and have the potential to accumulate cash value. The GPT ensures that the policy remains within the limits set by the IRS, maintaining its status as a life insurance policy with associated tax advantages.

Why is Section 7702 important?

Section 7702 is a crucial part of the IRS tax code because it defines which cash value life insurance policies qualify for tax advantages. If a policy doesn’t meet the requirements outlined in this section, both the growth of the policy’s cash value and the death benefit may be taxable as ordinary income. Fortunately, most life insurance policies today comply with these rules, so policyholders typically don’t need to worry about losing their tax benefits.

The origin of Section 7702 dates back to concerns about tax avoidance. In the early days of life insurance in the U.S., policies were designed to support widows and children without imposing tax burdens on them. By 1984, however, some wealthy individuals were exploiting these tax-free benefits by using life insurance policies as investment vehicles rather than for their intended purpose of providing financial protection. To address this, Congress introduced Section 7702, establishing specific criteria that life insurance policies must meet to maintain their tax-advantaged status. This ensures that life insurance is used appropriately and prevents its misuse as a tax shelter.

How Section 7702 plans work

There isn’t a specific “Section 7702 plan.” Instead, Section 7702 refers to the IRS guidelines that life insurance policies must meet to maintain their tax-advantaged status. These guidelines apply to various types of cash value life insurance policies, such as whole life, universal life, variable universal life and indexed universal life.

Here is how these policies typically work:

• Cash value accumulation: The cash value of the policy accumulates over time based on the premiums paid and any potential investment returns, dividends or interest credited to the policy.
• Tax-deferred growth: The cash value grows on a tax-deferred basis, meaning you do not have to pay taxes on the growth as long as it remains within the Section 7702 guidelines. Since tax codes can change, it is recommended to work closely with your agent to stay informed.
• Death benefit: This is the amount paid to beneficiaries upon the insured’s death. Under Section 7702, the death benefit is usually tax-free.
• Access to cash value: Policy owners can access the cash value through withdrawals or policy loans. Withdrawals are typically tax-free up to the amount of premiums paid (the owner’s basis). Policy loans are also generally tax-free as long as the policy remains active, but they accrue interest, which can impact the policy’s cash value and death benefit.

The amount of cash value that accumulates inside the policy depends on the type of policy and the amount paid into it over time. Variable policies have the potential for higher growth in the long run but can also decline in value when markets drop. Indexed universal life policies tend to be safer because the policyholder’s cash value is guaranteed not to decrease if the associated index performs poorly. However, there are trade-offs in your potential return. They usually have lower long-term growth potential compared to variable policies.

Frequently asked questions

• How is a 7702 plan different from a retirement plan?
  

  A 7702 life insurance plan refers to a cash value life insurance policy that includes a death benefit and a cash value component that meets IRS standards. While these policies can provide supplemental income in retirement, they are not the same as retirement plans like 401(k)s or IRAs. Cash value life insurance policies often come with higher fees and charges, while 401(k)s and IRAs typically have lower fees and are specifically designed for retirement savings. It’s important to understand the costs and benefits of each option when planning for retirement.

• What is the purpose of life insurance?
  

  The primary purpose of life insurance is to provide financial support to your loved ones after your death. It can help cover expenses such as funeral costs, outstanding debts (such as mortgages and car loans) and living expenses, ensuring that your beneficiaries are financially protected during a difficult time. Some life insurance policies also allow you to borrow against or withdraw cash value from the policy while you’re still alive. This can help you pay down debt in advance but there are interest charges associated with policy loans and may be consequences to the death benefit paid out to your beneficiaries after you die.

• What is a Modified Endowment Contract (MEC)?
  

  A Modified Endowment Contract, often simply referred to as a MEC, is a type of life insurance policy that fails to meet the criteria set by Section 7702. When a policy is classified as an MEC, it loses some of its tax advantages, such as tax-free loans and withdrawals. The earnings on a MEC are taxed as ordinary income when withdrawn, making it less favorable for those looking to use the policy as a tax-advantaged investment vehicle.

• What is the difference between the guideline premium test (GPT) and cash value accumulation test (CVAT)?
  

  Both the GPT and CVAT are two tests for a policy outlined in the Section 7702 IRS tax code. CVAT establishes that if a policyholder decides to surrender or cancel their policy, the money they receive from the cancellation cannot exceed the premiums they would have paid into it in one lump sum. GPT is used when the policyholder wants to maximize the amount of cash the policy accumulates. Whereas the CVAT focuses on maximizing the death benefit, the GPT focuses on the cash accumulation portion of a life insurance policy.

• Is the Section 7702 rule good or bad?
  

  Whether the 7702 rule is good or bad is relative, but for most people, Section 7702 will not be a concern. It’s only a concern if you are trying to put as much money as possible into your life insurance policy. The general goal of life insurance is to pay for funeral costs and alleviate your loved ones of any current or future debt the loss of your income may impact. If you are financially secure enough to pay more into a life insurance plan in order to take advantage of the tax-free advantages it provides, it might be a good thing. But if money is a concern, experts recommend focusing on what you and your family genuinely need and working with a trusted agent or financial consultant to accomplish your goals.