IRS Tax Code 7702 Insurance Plans
Tax Code 7702 is a part of the IRS tax code that explains how cash-value life insurance policies can keep their tax-advantaged status. Section 7702 life insurance plans refer to tax-advantaged life insurance policies named after that specific section of the IRS tax code. Tax code 7702 explains how cash-value life insurance policies retain their tax-advantaged status. A 7702 plan is not a type of life insurance policy, such as a term or whole life policy. To preserve tax-advantaged status, policyholders need to fully understand the type of policy they are choosing. Also, how premiums will be handled before signing a life insurance contract. This includes any potential tax benefits from the policy’s cash accumulation. Understanding IRS tax code 7702 will help to better understand a policy’s tax-advantage status and the impact on a cash value account.
What Is IRS Tax Code 7702?
Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code defines how the federal government views a valid life insurance contract. This section of the tax code is used to determine how the policy’s proceeds are taxed. Policy proceeds that do not meet the government’s definition are taxed as ordinary income. However, the proceeds of genuine life insurance contracts are tax-free. Section 7702 only applies to life insurance contracts issued after 1984. Prior to the implementation of Section 7702, federal tax law took a relatively hands-off approach to the taxation of life insurance policies. Therefore, death benefits paid to life insurance beneficiaries were exempt from income tax. Also, exemptions were applicable to any gains accumulated within the policy during the policyholder’s lifetime.
Section 7702 is important because it specifies which types of cash-value life insurance policies are eligible for tax breaks. If a life insurance policy fails to meet the criteria outlined in this section of the Internal Revenue Code, both the growth of the cash value inside the policy and the death benefit is taxable to the beneficiary. The federal government does not want to be seen taxing needy widows and children. However, issues began to arise when other types of investment accounts were misrepresented as life insurance products. To clarify this potential abuse, IRS Tax Code Section 7702 establishes a clear set of requirements. The goal is to ensure that only genuine life insurance policies receive favorable tax treatment. This is to discourage and eliminate investment vehicles masquerading as legitimate life insurance.
Requirements of IRS Tax Code 7702 Plans
Section 7702 of the Internal Revenue Code specifies the requirements that cash-value life insurance policies must meet. At least, in order to continue to be tax-favored. Tax Code 7702 code defines the premium payment guidelines as well as the corridor and cash value accumulation tests that must be met for the cash value of a permanent policy to grow tax-deferred. Section 7702 rules apply to any cash-value life insurance policy issued after 1985.
- Life insurance policies must pass one of three “tests” to qualify for tax advantages. Either a cash value accumulation test (CVAT), the guideline premium (GPT)), or the corridor test.
- If a contract does not meet the guidelines, the proceeds from the policy are simply treated as income.
- The term “7702 plans” does not refer to qualified retirement plans. Any cash-value life insurance policy you buy is subject to the same tax rules.
What is a Cash Value Accumulation Test (CVAT)?
Tax code 7702 outlines and defines the CVAT as one of the tests. The code states that the cash value test is met “if the sum of the premiums paid under the contract does not at any time exceed the guideline premium limitation as of that time,”. In other words, the money a policyholder receives from their policy if they decide to cancel cannot be more than what they would have paid for the policy in a lump sum, excluding fees. The cash surrender value is the amount of money received by the policyholder in the event of cancellation.
Term life insurance is an example of a policy that would pass the CVAT test. Term life insurance, unlike whole, universal, and variable policies, does not accumulate cash value. If you surrender your term life insurance policy, you will not receive any payout. Because most term policies do not have a cash value component, premiums for term life insurance are typically less expensive.
What is Cash Surrender Value?
The cash value accumulation test further states that the cash surrender 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.” In other words, the amount of money a policyholder could get out of the policy if they were to cancel it can’t be greater than the amount that the policyholder would have to pay at such time to fund future benefits under the contract. This is often referred to as the “savings” component of cash value life insurance.
What are the Guideline Premium & Corridor Test
The guideline premium and corridor test require that “the sum of the premiums paid under such a contract does not at any time exceed the guideline premium limitation as of such time.” This means the policyholder can’t pay more into the policy than is necessary to fund its insurance benefits.
Why is Section 7702 important?
Section 7702 is an important clarification of the Federal Tax Code. This is because it specifies which types of cash-value life insurance policies are eligible for tax breaks. The consequences are significant if a life insurance policy fails to meet the criteria outlined in this section of the Internal Revenue Code. Both the growth of the cash value inside the policy and the death benefit is taxable to the beneficiary.
Section 7702 of the Internal Revenue Code was enacted in response to the large number of cash-value life insurance policyholders who were using it as a tax shelter. Many policies issued prior to 1985 had enormous growth potential in their cash value component. As a result, these “policies” became more of an investment and less “life insurance policies”. The IRS attempted to prevent this by enacting Section 7702 rules. Since 1985, there have been set limits on life insurance cash values. These limits must be adhered to in order to maintain their tax-advantaged status.
Tax Code 7702 Insurance Plans – FAQs
Why Are Life Insurance Contracts Given Favorable Tax Treatment?
When a person dies, life insurance contracts are designed to pay out a cash benefit to their beneficiaries. However, some permanent life insurance contracts can accumulate a cash value. In turn, the cash can be withdrawn or borrowed against while the insured is still alive. For example, whole or universal life. Nevertheless, these contracts are viewed as insurance rather than investments. As such, they are eligible for certain tax breaks. A policy loan, for example, is not taxed.
What if a life insurance plan fails IRS Tax Code 7702?
Some life insurance policies fail to pass Section 7702 guidelines. In that instance, Section 7702(g) stipulates that the income on the contract will be treated as ordinary income. Therefore, it must be included for that year as income and taxed accordingly. In other words, the owner of the contract will lose the favorable tax treatment of a true life insurance policy.
For example, a modified endowment contract (MEC) is a permanent life insurance policy that fails the Section 7702 criteria. It fails because it has been “overfunded” with too much cash value relative to the size of its death benefit. This is defined by IRC Section 7702(a).
When Was Section 7702 of the Tax Code Adopted?
The Federal Tax Code, Section 7702, and all related subsections were enacted in 1984. The vast majority of life insurance policies today meet the criteria of this code. As a result, policyholders are rarely affected.
Are IRS Tax Code 7702 plans worth it?
If you decide to purchase a 7702 plan, you should do so for the life insurance benefits. These plans are not structured as a way to save for retirement. Consider it a life insurance policy that provides comprehensive coverage while also allowing you to save money. These policies should not be relied upon for retirement savings.
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