Have you ever heard of Section 7702 Plan?
I hadn’t either until a few weeks ago.
That’s when a colleague of mine reached out and asked me this very same question. While I was raised to never answer a question with a question – that’s exactly what I did.
I responded to my friend by asking “isn’t that the code section that governs life insurance contracts?”
To his disbelief he quickly replied “Yes!”
I said, “Let me take a guess. Somebody pitched one of your clients a Section 7702 Plan?”
He responded with “how did you know?”
All I could do was shake my head in disbelief.
What Is a Section 7702 Plan?
Technically, Section 7702 isn’t a plan at all.
It is simply a section of the Internal Revenue Code (IRC) defining what a life insurance contract is and how it is taxed. More specifically, it places limits on how much premium you can contribute to a policy relative to its death benefit.
How Did Section 7702 Come About?
Prior to 1985, a number of individuals recognized the tax benefits of permanent life insurance.
Without Section 7702 an individual could make a single, lump sum premium payment into a life insurance policy with very little death benefit.
Because the difference between the death benefit and policy cash value was so small it provided incredible tax benefits.
These benefits included:
- Income tax free death benefit,
- Tax-deferred growth on policy cash values, and
- Tax-free distributions from the policy in the form of withdrawals and loans
Essentially people were taking $1000,000 and buying a $100,1000 life insurance policy.
This allowed them to operate in a non-taxable environment. Essentially people were able to pass of investment as life insurance. Brilliant!
However, the Federal government didn’t see it the same way. They looked at how people were using these life insurance policies, and determined the tax benefits were too good to be true.
So what did they do?
Well, they passed Section 7702 of the Internal Revenue Code. The purpose being to limit the tax benefits of life insurance policies.
Section 7702 created guidelines and definitions of how a life insurance policy could be structured.
So…gone are the days where you could put $100,000 of premium into a life insurance policy with a $100,100 death benefit.
Section 7702 also made it so if a policy violated these guidelines, any gains would be distributed first and would be taxable.
Why Are People Out There Promoting the Section 7702 Plan?
The insurance industry and its agents are in the business of selling life insurance (surprise!). If somebody came to you and said I’ve got this great idea for you that involves using a life insurance policy for retirement you would run for the hills and avoid all phone calls from that person for weeks on end.
Now, if that same person came to you and said I’ve got this Section 7702 Plan that provides tax-deferred growth and tax-free withdrawals – do you have 30-minutes next week to sit down and discuss it – you would be more likely to agree to it.
Does that mean it’s a bad thing? Certainly not.
Does it mean it’s probably been over promoted and sold to people who shouldn’t have done it? Absolutely.
How Did Section 7702 Change Life Insurance Policies?
The introduction of Section 7702 created two significant changes to life insurance policies:
- It increased the amount of death benefit you were required to purchase based on certain premium guidelines, and
- If you violate these guidelines you are required to pay income tax on any gains distributed from the policy FIRST.
Life insurance policies still include:
- Income tax free death benefit,
- Tax-deferred growth, and
- Tax-free distributions in the form of withdrawals and loans provide you don’t violate the funding guidelines.
Because you must purchase more death benefit relative to the premium being paid, it makes using a life insurance policy for retirement or investment purposes less attractive today. This doesn’t automatically exclude the use of life insurance as a funding vehicle. It just means it use to be a lot better.
In fact, it was so good the IRS shut it down. This means it was really good. It’s still good. Just not as good.
In addition, there are number of public and private companies, banks, and individuals who use life insurance as a funding vehicle because of its inherent tax benefits.
SIDEBAR RANT: A Section 7702 Plan is not the only term used by life insurance advisors to promote the idea of an overfunded life insurance policy. There are many others. The brilliance of the people who come up with this stuff never ceases to amaze me.
Thoughts on the Section 7702 Plan
My initial thoughts are if you are promoting overfunded life insurance as a Section 7702 Plan then you have already shown not only ignorance, but deception.
Why would anyone want to work with somebody who is intentionally deceptive in order to sell something?
This is akin to renting a fancy car for a first date when your daily driver is piece of a junk – don’t do it.
Opponents to using overfunded life insurance for retirement would suggest there is no place or benefit to doing this (e.g. this would include investment advisors, finance planners, registered investment advisors, accountants, attorneys, etc.).
Life insurance advisors would likely suggest more people should take advantage of it for retirement.
I would suggest it probably falls closer to the middle then any of the abovementioned parties would like to admit. I’m not the biggest proponent of life insurance for accumulation. But, like anything, given the right set of circumstances there is a place for it.
If you have maximized contributions to retirement plans (e.g. 401(k), Ira, Roth Ira, etc.), and are looking for other tax efficient vehicles to supplement your retirement income then an overfunded life insurance policy MAY be appropriate.
Overfunding a life insurance policy is nothing new. When considering an overfunded life insurance policy there are two critical components:
- Policy design to ensure the death benefit is reduced to the minimum allowable amount under Internal Revenue Code Section 7702 based on projected premiums, and
- Annual (if not more frequent) reviews of the policy performance to ensure the participant understands how the policy is performing.
Final Thoughts on the Section 7702 Plan
I’ve got big news! Anyone who owns a permanent life insurance policy is already has a Section 7702 plan.
Whether you got the coverage for death benefit or accumulation – you are already taking advantage of Section 7702.
My only wish would be that we are able to go back to 1985 before Section 7702 or the idea of a Section 7702 plan existed.
About Jason Mericle
Jason Mericle is the founder of Mericle & Company. Partnering with a specialized team of advisors, he is able to help business owners significantly reduce taxes, protect assets, and create tax-favorable income.
He compliments his extensive knowledge of tax strategies and products with an in-depth understanding of the different tax and legal structures for which they are used.
About Jason Mericle
Jason Mericle is the founder of Mericle & Company. He has partnered with a unique team of professional advisors specializing in helping business owners significantly reduce taxes, protect assets, and create tax-favorable income.
Jason compliments his extensive knowledge of tax solutions and products with an in-depth understanding of the different tax and legal structures for which