IRC 7702 Pros and Cons

What Is an IRC 7702 Plan?

A 7702 plan is not a retirement plan, it’s a life insurance policy. In fact, any  life insurance policy could be called a “7702 plan” because all life insurance policies are covered by section 7702 of the Internal Revenue Code (IRC). Many insurance agents use the term “7702 plan” to avoid saying life insurance right away in conversations with potential clients. But obviously, life insurance is not inherently bad if it’s set up correctly to meet the proper needs.

Here at McFie Insurance, we design or review “7702 plans” for our clients daily – and we call these policies by their authentic names: Participating Whole Life Insurance, Indexed Universal Life Insurance, etc.

Many advisors will tell you that you should pay as little as possible for your life insurance. But high premiums are not always bad when you’re in the right financial situation. In fact, when a policy is designed well, higher premiums can help you build cash value and overcome the cost of insurance faster.

An IRC 7702 plan is a cash-value life insurance policy with higher premiums than a term insurance policy. There are many benefits of owning a high-premium-high-cash-value 7702 plan. We talk about some of these benefits later in this article.

How Does an IRC 7702 Plan Work?

An IRC 7702 plan works just like a life insurance policy because it is a life insurance policy. Your premium goes towards the purchase of a death benefit. The plan may build cash value as well. After death, your family is paid the death benefit from the policy / 7702 plan. The cash value can be used during your lifetime either by taking a withdrawal or leveraging that value to take a policy loan from the insurance company. Think of cash value as your equity in the life insurance death benefit.

Even though it is not accurate to refer to a 7702 plan as a “retirement plan,” good life insurance policies like we design at McFie Insurance can put you miles ahead when it comes to saving for retirement.

Saving for retirement with whole life insurance (aka a 7702 plan) can open better options for more sustainable retirement income than typical financial planning which relies mainly on tax-deferred plans such as 401(k)s and IRAs.

A typical investment portfolio cannot provide guaranteed growth. A good life insurance policy / 7702 plan will provide guaranteed growth on your money. This gives you confidence and financial peace of mind.

7702 Plans Compared to Traditional Retirement Accounts

As a type of life insurance policy, a 7702 plan represents an agreement between you and the insurance provider, where you pay premiums. Unlike retirement funds, these life insurance policies grow with tax-deferred benefits but do not provide tax deductions for your contributions.

When your employer provides a traditional 401(k) plan, it opens the door to accumulating a substantial retirement fund and enjoying tax-related perks, such as making contributions before taxes and deferring taxes on investment growth.

Specifically, the contributions you make, up to the yearly limit, aren’t taxed in the year(s) you make them. This potentially lowers your taxable income, leading to either reduced income tax payments or bigger tax refunds in those years.

Moreover, the tax-deferred growth of investments in a traditional 401(k) plan means you only pay taxes on the earnings when you withdraw them. This feature can significantly boost your account balance over time, as you’re earning returns on your original contributions, past earnings, and the money that would have been used to pay taxes.

Pros and Cons of 7702 Plans

Pros of 7702 Plans:

1. Tax-Deferred Growth of Cash Value: The cash value in a 7702 plan grows without immediate tax implications.
2. Tax-Free “Loans”: Funds can be accessed from the plan without tax penalties.
3.  No Contribution Limits: There are no annual caps on how much can be contributed.
4. Policy Loan Balance Repayment: Policy loans can be offset by death benefit proceeds after the policyholder’s death.
5. Tax-Free Death Benefit: Beneficiaries receive death benefits without income tax.
6. Consistent Premium Amount: Premiums often remain the same throughout the policy’s lifespan.
7. No Required Minimum Distributions (RMDs): Unlike some retirement accounts, RMDs are not mandated.
8. Exemption from Early Withdrawal Penalty: Withdrawals before age 59 ½ do not incur a 10% IRS penalty.
9. Creditor Protection: In some states, the policy offers protection against creditors or bankruptcy.

Cons of 7702 Plans:

1. No Tax Deduction for Contributions: Contributions are made with after-tax dollars.
2. Surrender Penalties: Early withdrawals may incur penalties during the surrender period.
3. Interest on Borrowed Funds: Loans taken from the policy typically accrue interest.
4. Potential Taxation of Cash Value: Excessive premium contributions could render the cash value taxable.
5. Health-Based Eligibility: The insured must meet health conditions to qualify.
6. Policy Lapse Risk: Failure to pay premiums can lead to policy lapse.
7. Slow Cash Value Growth: It may take time for the cash value to accumulate.

Utilizing IRC 7702 Plans Beyond Retirement

Besides offering a source of tax-free income in retirement, 7702 plans can aid in planning for expenses like college education, emphasizing the importance of early savings for such significant costs.

Section IRC 7702 Changes

In December 2020, Congress made changes to section 7702 for the first time since it was created 32 years before in 1988.

Through the Consolidated Appropriations Act, the minimum interest rates to be used in the design of cash-value life insurance products were changed to allow for continued low-interest rates across the rest of the economy.

Existing policy owners do not need to worry about their guaranteed policy values since these changes do not affect existing policy guarantees unless significant changes are made to an existing policy.

As of January 2022, life insurance companies have updated their new products in accordance with this legislation. Many companies have endeavored to keep high guaranteed cash values while dividends are projected somewhat lower across the industry. Premiums tend to be slightly higher in order to build similar cash value. 

None of these changes negate the value of using whole life insurance/7702 plan as an important financial tool and a liquid form of savings in addition to the permanent death benefit.

Seeing the numbers from the insurance companies we represent here at McFie Insurance, we think the findings of the Society of Actuaries have been reflected pretty accurately across the industry resulting in:

• higher guaranteed cash values;
• higher premiums to support those cash values;
• lower net amount at risk (less mortality risk);
• premiums and dividends applied to buy paid-up additions would purchase less death benefit; and
• less risk to the company in a sustained low-interest-rate environment.

Is a 7702 Plan Right for You?

IRC 7702 plans, while offering appealing benefits, might not be the best fit for everyone. However, you might find a 7702 plan advantageous if you:

1. Seek Additional Tax-Free Income in Retirement: If your goal is to increase your tax-free income during retirement.
2. Have Maxed Out Other Retirement Contributions: If you’ve already reached your contribution limits in your 401(k) or other qualified retirement plans and are looking for further tax-advantaged growth.
3. Desire Principal Protection in Various Market Conditions: If you want to safeguard your principal regardless of stock market fluctuations.
4. Wish to Access Benefits While Alive: If you’re interested in a plan that allows you to use certain benefits during your lifetime.
5. Prefer Not to Recover Losses Before Gaining Again: If you want to avoid the necessity of making up for losses before seeing gains.
6. Seek Financial Security with a Death Benefit: If having a death benefit for financial coverage in unexpected situations is important to you.
7. Want to Avoid Taxable Social Security Benefits: If you’re concerned about additional income making your Social Security benefits taxable.
8. Prefer No Mandatory Withdrawals Post-Age 72: If you don’t want to be obligated to withdraw funds at age 72, nor face penalties for not doing so.

Summary

An IRC 7702 plan is not a retirement plan. It’s a section of the internal revenue code that dictates how life insurance will be treated for tax purposes. Some experts say life insurance is the single largest benefit in the tax code. Thanks to section 7702, life insurance is not just effective for providing financial protection for your loved ones when you die, it is also a great way to grow your wealth while you’re alive. It can provide retirement income for you in your golden years and it lets you leave money to your spouse, your children, and your grandchildren income tax-free! With a better understanding of the IRC 7702 pros and cons, you can make more informed decisions about your life insurance for your financial success.

To see the numbers for a well-designed life insurance policy/7702 plan and how this could benefit you, call McFie Insuranceat 702-660-7000 or schedule a time for us to call you.