What is Section 7702
Section 7702 of the United States Internal Revenue Code defines what the federal government considers to be life insurance contracts and how they're taxed. Section 7702 imposes limitations on premiums and benefits relative to death benefits and defines what is considered life insurance for federal tax purposes. It applies to life insurance contracts issued after 1985.
BREAKING DOWN Section 7702
Prior to the writing of Section 7702, federal tax law took a fairly hands-off approach when it came to the taxation of life insurance policies. Death benefits paid to life insurance beneficiaries were free of income tax, distributions were taxed on a first-in-first-out (FIFO) basis and interest and gains that built up within the policy were not included as part of the policyholder’s current income. The reasoning behind this was that the government did not want to be seen taxing beneficiaries – children and widows – which would not go over well politically. The problem, however, was that the generous tax breaks given to insurance policies led people to try to pass investments off as life insurance.
Section 7702 was created in order to limit the tax benefits given to life insurance policies. It did this by defining what would be considered a life insurance policy, and investment vehicles that didn’t fall under the insurance definition were not eligible for the favorable tax treatments.
Under Section 7702, life insurance contracts had to pass one of two tests: the cash value accumulation test (CVAT) or the guideline premium and corridor test (GPT). The CVAT stipulates that the cash surrender value of the contract cannot exceed the net single premium required to fund future benefits. The net single premium is calculated using a combination of fixed interest rates, mortality charges and other contract charges. The GPT requires that premiums paid to date do not exceed the amount of one-time premiums that would fund the contract.
Section 7702 Life Insurance Classifications
As a result of Section 7702, there are now three classes of "life insurance" contracts:
- A policy that doesn’t meet the requirements of 7702 isn’t life insurance at all for federal tax purposes. As such, these types of policies aren’t generally available for purchase.
- A modified endowment contract (MEC) meets the requirements of 7702, but not 7702A. Gains in a MEC are still immune from taxation as long as they're realized through death, but distributions are subject to LIFO taxation and may incur an excise penalty.
- A “non-MEC” contract—one that fulfills all the requirements of both 7702 and 7702A—receives all the traditional tax benefits of life insurance.