What is Section 7702?
Section 7702 of the U.S. Internal Revenue Code defines what the federal government considers to be a legitimate life insurance contract and determines how such contracts are to be taxed. It applies to life insurance contracts issued after 1985.
Understanding Section 7702
Prior to the adoption 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 from income tax, and any gains that built up within the policy during the policyholder's lifetime were not taxed as part of their income.
Aside from the insurance industry's formidable lobbying power, the reasoning behind this favorable tax treatment was that the government did not want to be seen taxing needy beneficiaries—typically widows and children—which would not go over well politically. The problem, however, was that the generous tax breaks given to insurance policies led some companies to try to pass off other investments as life insurance.
Life insurance policies that fail to pass the tests in Section 7702 lose any potential tax benefits.
Section 7702 was created to differentiate between genuine life insurance policies and investment vehicles masquerading as them and to make sure that only proper policies received the advantageous tax treatment traditionally accorded life insurance.
- The cash value accumulation test stipulates 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." That basically means that the amount of money the policyholder could get out of the policy if they were to cancel it (often thought of as the "savings" component of cash value life insurance) can't be greater than what the policyholder would have paid to purchase the policy with a single lump sum, not including any fees.
- The guideline premium and corridor test requires that "the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitation as of such time." That basically means that the policyholder can't have paid more into the policy than would be necessary to fund its insurance benefits.
What happens if a life insurance contract fails to pass either of those tests? Section 7702(g) stipulates that the "income on the contract" will be treated as ordinary income to the policyholder for that year and taxed accordingly. In other words, it will lose the favorable tax treatment of a true life insurance policy.
In recent years, some insurance companies and agents have invoked the name of Section 7702 in offering so-called "7702 plans," which they position as a safer alternative to IRAs and 401(k) plans for retirement savings. While 7702 plans may sound official, they are little more than a marketing gimmick to sell cash value life insurance, and they're unlikely to be a better deal than an IRA or a 401(k) once all the commissions and fees have been taken into account.