Section 7702: Life Insurance Contract Definition

KEY TAKEAWAYS

• Section 7702 of the IRS Tax Code defines the specifics of a legitimate life insurance contract. It also helps differentiate an insurance product and income generated from an investment vehicle.
• Proceeds earned from a life insurance contract often receive tax advantages.
• Any proceeds earned through a life insurance contract that aren’t aligned with the IRS definition get taxed as ordinary income.
• There are many types of permanent life insurance that can increase in cash value over a period of time.

What Is Section 7702?

Section 7702 is a specific section of the Internal Revenue Service (IRS) Tax Code in the United States that establishes and defines the details of a valid life insurance contract. 

There are two tests that must be met in order to qualify the life insurance contract. Any proceeds that are not aligned with the federal government’s definition would get taxed as ordinary income, however, any proceeds generated from a legitimate life insurance contract are going to be tax advantaged. It’s worth noting that Section 7702 only applies to life insurance contracts that were issued after 1984.

Requirements of Section 7702

When it comes to life insurance contacts, they must pass one of two separate tests. These are the guideline premium and corridor test (GPT) and the cash value accumulation test (CVAT). Let’s take a closer look at how each of these works. 

Guideline Premium and Corridor Test

This test ensures that a policyholder won’t pay more into a policy than what’s actually necessary to fund the insurance benefits. The requirement states that “the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitations as of such time.”

Cash Value Accumulation Test

With this test, Section 7702 outlines the cash surrender value of the life insurance contract. The IRS states that the value of the contract “may not at any time exceed the net single premium which would have to be paid at such time to fund future benefits under the contract.”

If a life insurance policy doesn’t pass either test then Section 7702(g) outlines that any income earned will get treated as ordinary income. This income would then get taxed accordingly. The policyholder basically loses any favorable tax treatment that would come with a true life insurance policy. 

How Does Section 7702 Plan Work?

Before getting too far into how Section 7702 plans work, it’s important to understand that they aren’t specific types of life insurance policies. Rather, they’re specific and standalone cash value life insurance policies like a whole life insurance policy.

These plans also differ from traditional retirement plans, such as an individual retirement account (IRA) or a 401(k). To help put this into perspective, a 401(k) plan allows pre-tax contributions and 7702 plans are entirely funded with after-tax money. 

When you contribute to your Section 7702 plan, you aren’t able to deduct the premium costs from your taxes like you could with a 401(k) retirement plan. This is hence the IRS sees these costs as personal expenses, not retirement plan contributions. The cash value of the life insurance policy increases tax-deferred and policyholders are even able to take out a tax-free policy loan.

The specifics of a 7702 plan can vary slightly. For example, they can be a:

• Whole life policy
• Universal life policy 
• Variable universal life policy
• Indexed universal life policy 

How much cash you’re able to accumulate in your policy will depend on when you sign up for your life insurance policy. It also considers how much has been paid into it over a period of time. A variable life insurance policy has a high potential to generate growth in the long run. However, they can also see a decrease in value if the market drops. 

An indexed universal life policy can be a more conservative approach since the cash value won’t decrease if the associated index doesn’t perform well. But on the flip side, they have a much higher potential for long-term growth compared to a variable policy. No matter the policy you decide to use, any qualified Section 7702 plan will include tax-free death benefits.

Is There a Difference Between a 7702 Plan and a Retirement Plan? 

A section 7702 plan is a specific type of cash-value life insurance policy. This means that it has a cash value that goes beyond the potential death benefit. Paying premiums into this kind of policy means a portion goes to the death benefit and a portion goes to the policy’s cash value. 

You might get offered a 7702 plan from your employer as part of your employee benefits package. And while they can sometimes get described as a type of retirement plan, 7702 plans have some differences that are worth understanding. It will work differently compared to the standard 401(k) or other workplace retirement savings options. 

A 7702 plan accumulates cash value throughout the period of the policy. Depending on your employer, it could be a universal life insurance policy or a variable life insurance policy, for example. The cash value will continue to grow on a tax-deferred basis. 

Here are a few of the key differences between a 7702 plan and a retirement plan:

• 7702 plans have no tax deductions
• Contributions made to a traditional IRA or 401(k) can be tax-deductible
• You will pay income tax on any qualified withdrawals from a retirement plan
• You can withdraw the cash value of a 7702 plan tax-free as long as it’s not more than what you’ve put in
• With a tax-free death benefit, you can pass on a cash value policy to a beneficiary 

While a 7702 plan and a retirement plan might sound fairly similar, they operate in completely different ways. A cash value life insurance policy can sometimes be an excellent financial strategy to pursue. However, it’s not always going to be a perfect solution as a retirement plan if you want to invest for the long term. 

Why Is Section 7702 Important?

Section 7702 plays an integral role in dictating how cash value life insurance policies receive tax-advantaged treatment. If a policy doesn’t quite line up with the IRS Tax Code criteria, then the growth of the cash value within the policy becomes taxable income. This works the same way when it comes to the death benefit of the policy. 

This isn’t often an issue for most policyholders as the majority of today’s insurance policies meet the criteria. Section 7702 was created because many life insurance policyholders were using them as tax shelters. 

In many cases, policies issued prior to these changes in 1984 saw substantial growth in the cash value component of the policy. After these new rules came into play, there are set limits to life insurance cash values. These limits must be followed to ensure the policy keeps its tax-advantaged status.

What Are the Challenges to Section 7702? 

After the IRS made changes to how life insurance policies get issued, the biggest challenge faced was implementing these new rules. This meant insurance providers needed to develop new solutions and integrate new types of software. 

Traditionally, company retirement plans such as defined contributions, profit-sharing, 401(k), and simplified employee pensions (SEO) were the go-to approaches. Having a plan that’s constructed properly with government approval allows some retirement contributions to become tax-deductible. 

Those types of retirement plans offered policyholders better opportunities to accumulate and distribute compared to simple saving or investing. The major downside is that these plans must qualify to be eligible for the specific tax benefits and they must adhere to the regulations the IRS has stipulated. 

The biggest challenge many business owners face with section 7702 is that allowable contributions can significantly vary by policy type. Plus, the policies can often be limited by certain regulatory requirements.

Summary 

A cash-value life insurance policy can sometimes be a much better fit for your personal situation compared to a term life insurance. It’s important to explore and weigh your financial situation to determine the best path forward. 

In part, Section 7702 of the IRS Tax Code was designed to ensure cash value life insurance policies aren’t getting used as tax shelters. It defines how the government legitimizes a life insurance contract. And it determines how any proceeds generated by the policy will get taxed.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.