702(j) Retirement Plan

What Is a 702(j) Retirement Plan?

If you don't know what a 702(j) retirement plan is, don't worry. You're probably not alone because not too many people know about it. Despite the official-sounding name, it isn't actually a retirement account. Instead, the 702(j) plan is a fancy marketing term for a type of permanent life insurance policy that is governed by section 7702 of the U.S. Code. Confusing, right?

The 702(j) plan provides insured individuals with life insurance and the option to overfund their policies as a savings component. This allows them to make cash withdrawals as income during their retirement years, hence the "retirement plan" portion of the product's name.

Professionals who sell these products say they provide returns that are 40 to 60 times higher than what you'll get from your bank account, which isn’t hard considering most savings accounts pay less than 0.1% interest. Supporters claim they allow you to borrow for major purchases. They also say that they are a secret type of account that the government doesn’t want you to know about but that major influential people are pouring their own money into—which is highly questionable.

If you've gotten this far and you still want to know more, keep reading to see how the 702(j) plan relates to retirement and whether this option may be the right fit for you.

Understanding a 702(j) Retirement Plan

Before we do anything else, it's important that we make a clear distinction between this product and others that may sound like it. If you aren't contributing to one of them, then you've undoubtedly heard of the 401(k), 403(b), or 457(b) plans. These are retirement plans that are named after sections of the U.S. tax code. The same isn't true for the 702(j) plan, as there isn't a related section of the tax code that relates to retirement plans or tax-deferred savings.

Several section 702s exist within the tax code and there's even a section 702(j) in chapter 15 of title 33 that deals with projects relating to tributary streams. But no section 702(j) of the tax code exists that deals with investments. Housed within the United States Code, which codifies all general and permanent laws of the country, is section 7702. It deals with the tax treatment of insurance products.

Whatever the reason, calling a policy a 702(j) plan is “a fancy way to dress up life insurance,” according to Richard Sabo, founder of RPS Financial Solutions and insurance industry whistleblower. “Life insurance is one of the highest commission products in the industry, and therefore people have been selling it as all kinds of things for years, but it is just life insurance."

Section 7702 is what these 702(j) plans are hearkening to. Essentially, they are permanent life insurance policies governed by that section of the U.S. Code. Why one of the "7"s is dropped, and where the "j" comes from, is a mystery—possibly, it's to make the vehicle sound more like a 401(k) or 403(b).

A 702(j) Plan As a Permanent Life Insurance

As mentioned above, a 702(j) retirement plan isn't a retirement plan. It's actually a permanent life insurance policy. And it may be marketed under different names like the 7702 plan, 7702 private plan, Infinite Banking Concept®, Bank on Yourself®, Become Your Own Bank, or even as high cash value life insurance.

“Insurance agents have used this term and topic a great deal over the past few years to convince people to buy permanent life insurance,” says independent broker Samuel R. Price, who works with Assurance Financial Solutions.

The plan works the same way a whole life or universal life insurance does, which means you purchase a contract through an insurance company or financial planner. You can’t open one up through your employer, your bank, or your brokerage. Once you sign up, you pay premiums to the company in exchange for coverage. These payments go toward the death benefit that is paid out to your beneficiary(s) and the total cash value of the policy.

Like some other policies, the 702(j) plan comes with a savings component built into it. This means that you can overfund your policy. Any excess cash you pay in addition to your premiums goes to the cash value, which is invested on your behalf. Any earnings on this portion of the policy are tax-deferred, which allows you to make withdrawals against this portion of the policy if you need it during retirement or in emergencies.

Investing in a permanent life insurance policy and borrowing against the cash value it accumulates tax-free is not a new concept. Can you use a 702(j) policy for retirement income? Absolutely. But it’s not the best option for most people, and it shouldn’t be anyone’s sole option.

Funding and Withdrawing From a 702(j) Plan

As with any other type of investment or insurance product, it's important to know how your premiums work and what the implications are when you make withdrawals.

Premiums

Funding a 702(j) policy requires a number of years of premium payments, say seven to 12 years. In order to accumulate the cash value, you must pay above the minimum. This allows your policy to accumulate its cash value slower than it would if you made a single premium payment, but faster than it would if you spread those premiums over, say, 30 years. Lots of people can’t or don’t want to pay a large single premium—they want to pay monthly or annually as they earn money from working.

What you can’t do over those seven to 12 years is to pay too much in premiums. But what exactly is too much? That's a bit complicated. If you put too much money into your plan, becomes a modified endowment contract (MEC). This is the term given to an insurance product whose funding goes over federal legal limits. Distributions taken from MECs are subject to taxes and possibly penalties.

According to section 7702, your 702(j) plan must pass two tests in order to qualify as insurance:

• The Cash Value Accumulation Test: The policy's cash surrender value can't exceed the amount they would have paid with a lump-sum premium when they cancel the contract.
• The Guideline Premium and Corridor Test: According to this test, the policyholder's premiums can't exceed what is necessary to fund the policy benefits.

Making Withdrawals

If you need money during your retirement years (or before that), you can get it by borrowing from your 7702 policy’s cash value. Like a retirement account, such as a 401(k) or an individual retirement account (IRA), the cash value of your policy grows tax-deferred. But unlike those types of accounts, when you take money out of a 7702 policy, you don’t pay income tax, and there’s no penalty for taking money out before age 59½.

But remember, this is technically a loan. This means that you have to pay interest on any withdrawals you make. And you can’t withdraw 100% of the policy's cash value. Doing so can cause the policy to lapse because it creates a huge tax bill from what Chris Acker, a term life insurance agent, calls “phantom income.” Most insurance companies won't let you borrow more than 90% of the cash value and have safeguards in place to prevent your policy from lapsing.

This is why Price says consumers should research companies and choose their insurers wisely by comparing over-loan protection rules. And Sabo warns against taking out too many loans against your policy because your loan value could get as high as the policy's cash value, which causes the policy to lapse. All your loans could become taxable at one time. If you want to keep your policy truly tax-free, keep it until your death, at which time the outstanding loans and interest are subtracted from the death benefit.

For this reason, a 7702 policy that you want to use as a retirement vehicle is not a good way to provide a death benefit for your heirs. Its purpose is to allow you to borrow against the policy’s cash value while you’re alive.

Advantages and Disadvantages of a 702(j) Plan

While most non-retired Americans have a retirement savings account, only 36% felt they were "on track," while only one-quarter of those surveyed had no retirement plan at all. But let’s say you fund your retirement accounts to the max every year. What more could you be doing to save in a tax-advantaged way? Insurance may be the way. But if you're thinking of a 702(j) policy, you'll have to understand the pros and cons of signing up.

Advantages

A 702(j) plan often makes sense for anyone worried about the tax consequences associated with traditional retirement savings accounts and Social Security benefit income. The plan also allows you to offset Medicare Part B premium surcharges that you may have to pay. While some of these concerns affect the middle class (especially the upper-middle class), they certainly do affect people in higher tax brackets.

Signing up for a 702(j) plan also provides you with tax diversification. As such, it offers you a source of revenue that is not counted as income and is not taxed as ordinary income because it’s a loan against the cash value of your policy.

Another benefit is that “permanent (whole) life insurance can be a hedge against a negative sequence of returns," according to Price. This allows you to withdraw cash out of your policy in years where other, traditional investments are doing poorly and it isn't the optimal time to liquidate them for income.

Disadvantages

The major drawback comes from the fees and commissions you pay to have a 702(j) plan. Before you sign, ask yourself whether it makes sense for you to pay an insurance company for the privilege of being able to borrow back their own money, with interest—even if that money does grow tax-free.

“There are upfront charges such as sales loads, monthly expense charges and the cost of insurance as well as various fees which stunt the growth of the cash value,” according to Sabo. He suggests investing that excess capital in a retirement account like a 401(k). A health savings account (HSA) is another good option for those willing to risk a high-deductible health plan (HDHP).

Like any other type of insurance product, 702(j)s aren't for everyone. In fact, they're usually suited for a small subset of people who have exhausted most other uses for their excess cash.

What Should You Look for?

The 702(j) plan should be the right fit if you want it work for your situation. According to Acker, the "dividends have to pay the right way, the loan has to be structured the right way, and it’s got to be serviced and illustrated the right way.” As such, servicing the policy well is essential to its effectiveness.

A good policy has what’s called “non-direct recognition” as opposed to “direct recognition.” With non-direct recognition, you end up earning the same dividends whether you borrow money from your policy’s cash value or not. Since the whole purpose behind the strategy of using life insurance for retirement income is to borrow money from the cash value, you don’t want a policy whose dividends decrease when you take a policy loan.

As noted above, be sure you research the insurers' policies on over-loan protection. But don't forget their rules about loan repayment. They need to make sure loans are repaid on a schedule. They should also make sure you don’t overfund your policy, which means it could be converted to a MEC and lose the tax advantages you’re seeking. That would run against the purpose of a “702(j) plan," which is to provide an additional source of tax-free retirement income.

What about the tax-free growth of your cash value? A 702(j) policy not only gives you a rate of return when the markets are doing well, but it doesn’t lose money when the markets are doing poorly. Your downside is limited—but so is your upside. A good policy will have a relatively high upside so you can benefit more during a bull market. But it only makes sense that if you’re going to have limited losses, then you’re also going to have limited gains.

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