What Is Section 7702?
Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code defines what the federal government considers to be a legitimate life insurance contract and is used to determine how the proceeds are taxed.
The proceeds of policies that do not meet the government's definition are taxable as ordinary income. Proceeds from genuine life insurance contracts are tax-advantaged.
Section 7702 applies to life insurance contracts issued after 1984.
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 exempt from income tax, and any gains that accrued within the policy during the policyholder's lifetime were not taxed as income.
- Section 7702 of the Tax Code differentiates between income from a genuine insurance product and income from an investment vehicle.
- The proceeds of a true life insurance contract receive favorable tax treatment.
- The proceeds of a contract that does not meet the IRS definition are taxed as ordinary 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 widows and children. The problem was that the generous tax breaks given to recipients of the proceeds of insurance policies led some companies to try to pass off other investment accounts as life insurance products.
The owner of a life insurance policy that fails Section 7702 tests loses 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 the genuine policies received advantageous tax treatment.
- 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 means that the amount of money a policyholder could get out of the policy if they were to cancel it (often referred to as the "savings" component of cash value life insurance) can't be greater than the amount that the policyholder would have paid to purchase the policy with a single lump sum, not including any fees.
- The guideline premium and corridor test require that "the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitation as of such time." This means that the policyholder can't have paid more into the policy than would be necessary to fund its insurance benefits.
If the Contract Fails the Test
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 for that year and taxed accordingly. In other words, the owner of the contract will lose the favorable tax treatment of a true life insurance policy.
In recent years, some insurance companies and agents have invoked Section 7702 in offers of so-called "7702 plans." These are sold as safer alternatives to IRAs and 401(k) plans for retirement savings.
This is a marketing gimmick to sell cash value life insurance. In fact, it's unlikely to be a better deal than an IRA or a 401(k) once all of the commissions and fees have been taken into account.