When you’re researching ways to fund your retirement, you might come across something that goes by one of these names:
- 702(j) plan
- 7702 plan
- 7702 private plan
- Infinite Banking Concept®
- Bank on Yourself®
- Become Your Own Bank
- High cash value life insurance
Those marketing these products or strategies say they provide returns 40 to 60 times higher than the earnings from the cash sitting in your bank account (which isn’t hard when bank accounts pay 0.01% interest) and that they give you a way to borrow for major purchases without having to qualify through a lender (which is true). They also say that the vehicles are a secret type of account that the government doesn’t want you to know about but that major political figures, billionaires and bankers are pouring their own money into (which is highly questionable).
So should you sign into your brokerage account right now and open up a 702(j)? Nope, it’s impossible to do that—but not because the government is keeping you from doing so. You can’t open up a 702(j) account through your employer, your bank, or your brokerage because there’s no such thing.
But you can buy one from your friendly insurance agent or financial planner. A 702(j) plan is just a marketing term for a permanent life insurance policy governed by section 7702 of the U.S. Code. “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 Samuel R. Price, an independent broker with Assurance Financial Solutions in Birmingham, Ala. that sells life, disability, and long-term care insurance.
To understand how all this relates to retirement and savings plans, read on.
702(j) Plan a Misnomer
First, let's define our terms. When we say there's no such thing as a 702(j) plan, we mean this: Unlike 401(k), 403(b) or 457(b) plans, which are named
after their respective sections of the tax code, there is no section 702(j) of the tax code that relates to retirement plans or tax-deferred savings.
There are several section 702s within the tax code (in titles 5, 15, 17, 32, 33, and 44, for example); 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.
Now, within the United States Code, the codification of all the general and permanent laws of the U.S., there is a section 7702, which deals with the tax treatment of insurance products. (To be more specific, we’re talking about Title 26, Subtitle F, Chapter 79, Section 7702.) There is even a section 7702(j), though that deals with “Certain church self-funded death benefit plans treated as life insurance.”
702(j) Plans Are Insurance Policies
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).
Whatever the reason, calling a policy a 702(j) plan is “a fancy way to dress up life insurance,” says financial consultant and advisor 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."
Indeed, permanent life insurance—whole life, variable life or universal life—that accumulates a tax-free cash value which policyholders can borrow against is not a new concept. Can you use a section 7702 insurance policy for retirement income? Absolutely.
But it’s not the best option for most people, and it shouldn’t be anyone’s sole option.
The Benefits of a 7702 Insurance Policy
Most Americans are not contributing to their retirement-savings accounts the maximum annual allowable amounts, and one-third of American adults have nothing saved for retirement. But let’s say you are funding your retirement accounts to the max every year. What more could you be doing to save in a tax-advantaged way?
A 7702 insurance policy might be a good option. It also often makes sense for people who are worried about the tax consequences of required minimum distributions (RMDs) from traditional IRAs and 401(k)s, paying tax on their Social Security income, or paying Medicare Part B premium surcharges. Some of these concerns affect the middle class, especially the upper middle class. But they definitely affect the wealthy.
A 7702 policy provides what’s called “tax diversification.” It provides a source of “income” that is not counted as income or taxed as income because it’s really a loan against the cash value of your policy.
Another potential benefit, as Price explains, is that “permanent life insurance can be a hedge against a negative sequence of returns," letting a policyholder draw cash out of their policy in years where their traditional investments have done poorly and it isn't the optimal time to liquidate them for income.
But you have to get a well-constructed policy from a top-notch insurance company and you have to understand how it works.
How Funding a 7702 Policy Works
When you buy any type of life insurance, you pay premiums in exchange for coverage. When you buy term life insurance, car insurance, or homeowners insurance, almost all of your premium dollars go toward insurance, with some percentage going toward the insurance company’s operating costs.
When you buy permanent life insurance, part of your premiums goes toward the cost of insurance (which is what provides a death benefit for your heirs), part goes to sales commissions (which compensate the broker or agent who sells you the policy), and part goes to the insurance policy’s cash value, which is sort of like a savings or investment account attached to an insurance policy. But, to be clear, the cash value is not actually a savings account or an investment account (see more on this topic in the next section). It seems like it’s your money, but when you die, the insurance company keeps it. It will not go to your beneficiaries.
Let’s go more in-depth on premiums. Permanent life insurance can offer flexibility in the amount of premium you’re required to pay. Instead of paying monthly or annual premiums, for example, you could pay one big premium at the beginning (this is called single premium life insurance). Your policy would then be fully funded. At the other extreme, you could pay the minimum, the smallest amount that will keep your policy in force.
With a 7702 policy, you do something in between those two extremes. You pay premiums for several years, perhaps seven to 12, but you pay more than the minimum. By doing so, your policy accumulates 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 is pay too much in premiums over those 7-to-12 years. What’s “too much?” It’s complicated, but if you pay too much, the tax code says your policy is no longer insurance, but a modified endowment contract (MEC). MEC distributions are subject to taxes and possibly penalties.
How to Withdraw Money From a 7702 Policy
If you need money in retirement—or at any other point—you can get it by borrowing from your 7702 policy’s cash value. Like a retirement account, such as a 401(k) or 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 this is technically a loan, and so you have to pay interest on the funds you withdraw. Interest rates in today’s relatively low-rate environment might range from 1% to 6% depending on the policy.
And you have to be careful about how much you borrow. You can’t withdraw 100% of the cash value, because doing so will cause the policy to lapse. A lapse is a big problem because it creates a huge tax bill from what Chris Acker, a term life insurance agent based in Redwood City, Calif., calls “phantom income.” Ideally, the insurance company will not allow you to borrow more than 90% of the cash value and will have safeguards in place to prevent your policy from lapsing.
“Consumers need to be very careful in selecting their insurance company for permanent insurance, since if the policy lapses from taking too much of the cash value, taxes can be owed on years of accumulation,” Price says. “Some insurance companies are better than others and build policies with over-loan protection that guards the policyholder against taking too much cash out of the policy. Others are not so good and do not forewarn the policyholder when their policy is about to self-destruct.”
As Sabo further explains, if you are constantly taking out loans on the policy and being charged loan interest, your loan value could get as high as your cash value, and that’s when the policy lapses. Then, all those loans become taxable at one time. It is “very tricky” to make sure the loans are true tax-free distributions, he adds. The only way for the policy to be truly tax-free is if you keep the policy 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.
Characteristics of a Good 7702 Policy
The problem with using 7702 life insurance in this way, Acker explains, is that “everything has to happen the right way: 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.” Servicing the policy well is essential to its effectiveness.
The insurance company needs to make sure the client pays back the loans on a schedule, he says. The insurer also makes sure you don’t overfund the policy, which would cause it to be a MEC (as mentioned above) and therefore lose the tax advantages you’re seeking. That would definitely run against the purpose of a “702(j) plan," which is to provide an additional source of tax-free retirement income.
A good 7702 policy will also have what’s called “non-direct recognition” as opposed to “direct recognition.” With non-direct recognition, you will earn the same dividends whether you have borrowed 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.
What about the tax-free growth of your cash value? A 7702 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.
The Downsides of 7702 Policies
Even if you have a good 7702 policy, you’re still paying those commissions and fees, which are one of the biggest drawbacks to any type of permanent insurance. “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,” Sabo says.
“If you put money in a 401(k), then 100% of your money goes into it and is invested. The underlying investments may have some expense charges, but your money is being fully invested.” By contrast, Sabo further explains, “if you put money into a life policy, they take a sales charge off the top, they charge a monthly administrative charge and there is the cost of insurance. Therefore, how is it such a great investment if you are going backward before you even start?”
Let’s say you’re willing to pay those fees. Is the insurance company willing to break down exactly how much of your premiums is going toward those costs? A company that’s transparent and providing you with honest numbers may be a company you actually want to give your premium dollars to.
Still, what else could you buy with the money that goes toward the insurance company’s costs? Are those costs worth it to you, in your situation, to obtain the benefits of a 7702? That’s a question only you can answer – ideally with the help of a fiduciary financial advisor who isn’t trying to sell you anything except advice and who is legally required to put your best interests above their own. And if you’re wealthy, you also want that advisor to be one who specializes in helping high net worth clients.
The Bottom Line
A 702(j) plan is just a marketing term for a permanent life insurance policy governed by section 7702 of the U.S. Code. These types of insurance policies are not scams, but they are only appropriate for a small subset of people who are wealthy and have exhausted most other uses for their excess cash. Even then, these policies have various complexities and pitfalls that prospective policyholders must be sophisticated enough to understand.
Furthermore, it does not make sense for most people to pay commissions and fees to 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.
For the majority, fully funding IRAs and retirement accounts offered by employers are the best ways to “bank on yourself.” The most popular retirement plans are traditional and Roth IRAs. An HSA is another good option for those willing to risk a high-deductible health insurance policy.