Life Insurance's 7702 Plans: What You Need To Know

Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code defines what the federal government considers a legitimate life insurance contract and is used to determine how the proceeds the policy generates are taxed. It outlines the criteria that life insurance policies must meet to qualify for tax advantages. If a life insurance policy does not meet the guidelines specified in Section 7702, the proceeds may be taxable as ordinary income.

The definition of a life insurance contract

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. It outlines the criteria that life insurance policies must meet to qualify for tax advantages. This section of the tax code differentiates between income from a genuine insurance product and income from an investment vehicle.

The term '7702 plan' is a loose marketing term and not a specific type of life insurance policy. It typically refers to the tax treatment of cash value life insurance policies, which can include whole, universal, variable, or indexed policies. These policies are intended by design to provide a cash benefit to beneficiaries upon the death of the insured. While the insured is still alive, permanent life insurance contracts can accumulate a cash value that can be withdrawn or borrowed against.

To be considered a life insurance contract under Section 7702, a contract must meet certain requirements, including passing 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 may not at any time exceed the net single premium that would be paid to fund future benefits under the contract. In simpler terms, the cash value of the policy must stay within limits set by the IRS.

The GPT has two parts: the guideline premium test and the corridor test. The guideline premium test ensures that the total premiums paid do not exceed the maximum amount allowed for the policy to qualify as life insurance. The corridor test requires that the death benefit is sufficiently higher than the cash value to meet IRS guidelines.

Life insurance contracts that do not meet the definition of a life insurance contract under Section 7702 are taxed as ordinary income. Additionally, if a life insurance policy fails to meet the criteria, it becomes a modified endowment contract (MEC) and permanently loses its tax-advantaged status.

Section 7702 was enacted in 1984 to address concerns about tax avoidance. Prior to its adoption, federal tax law took a hands-off approach to the taxation of life insurance policies, exempting death benefits from income tax. However, by 1984, some wealthy individuals were exploiting these tax-free benefits by using life insurance policies as investment vehicles. Section 7702 established specific criteria to ensure that only genuine life insurance policies received advantageous tax treatment.

The cash value accumulation test

For instance, if a policyholder has a whole life insurance policy, the CVAT ensures that the cash value they could receive if they cancelled the policy is not more than the single payment needed to buy the policy upfront. Whole life insurance policies accumulate cash value over time, and the CVAT ensures this value remains within the limits set by the IRS. By meeting this test, policyholders can benefit from the tax advantages linked with genuine life insurance policies.

The CVAT, therefore, ensures that the amount of cash one could obtain from cancelling the policy isn't more than what would be necessary to fund the policy's future benefits. If a life insurance policy fails to pass the CVAT or the other test, the guideline premium and corridor test (GPT), it loses its tax-advantaged status, and the income on the contract will be treated and taxed as ordinary income.

The guideline premium test

The Guideline Premium and Corridor Test (GPT) is a two-part test that determines whether a life insurance policy qualifies for tax advantages. It is one of two tests that a life insurance contract has to pass to be considered a legitimate life insurance contract by the U.S. Internal Revenue Service (IRS) and to receive tax advantages. The other test is the Cash Value Accumulation Test (CVAT).

The first part of the GPT is the Guideline Premium Test, which limits the amount of premiums that can be paid into a policy at any given time. The limit depends on the insurance company's expenses and claims experience. This part of the test ensures that the policyholder doesn't pay more into the policy than necessary for it to be considered life insurance.

The second part of the GPT is the Corridor Test, which requires that the policy's death benefit always exceeds a specified multiple of its cash value. This multiple can vary based on the insured individual's age. If the cash value exceeds this corridor, the policy is determined to be overfunded and is classified as a Modified Endowment Contract (MEC). MECs lose the tax benefits associated with life insurance.

The corridor narrows as the insured individual gets older, allowing for policies to endow at maturity.

Universal life insurance policies often use the GPT. These policies allow for flexible premiums and can accumulate cash value. The GPT ensures that the policy remains within the limits set by the IRS and maintains its status as a life insurance policy with associated tax advantages.

The corridor test

The GPT is a two-part test. The corridor test is one part, and the guideline premium test is the other. The corridor test requires that the death benefit of a life insurance policy always exceeds a specified multiple of its cash value. This multiple can vary based on the insured individual's age. If the cash value exceeds this corridor, the policy is determined to be overfunded and is classified as a Modified Endowment Contract (MEC). MECs lose the tax benefits associated with life insurance.

The corridor narrows as the insured person gets older, allowing for policies to endow at maturity. Universal life insurance policies often use the GPT. These policies allow for flexible premiums and can accumulate cash value. The GPT ensures that the policy remains within the limits set by the IRS and maintains its status as a life insurance policy with associated tax advantages.

The guideline premium test ensures that the total premiums paid do not exceed the maximum amount allowed for the policy to qualify as life insurance. The limit can vary based on the insurance company's expenses and claims experience. Essentially, it ensures that the policyholder doesn't pay more into the policy than necessary for it to be considered life insurance.

A 7702 life insurance plan refers to a cash value life insurance policy that includes a death benefit and a cash value component that meets IRS standards. While these policies can provide supplemental income in retirement, they are not the same as retirement plans like 401(k)s or IRAs. Cash value life insurance policies often come with higher fees and charges, while 401(k)s and IRAs typically have lower fees and are specifically designed for retirement savings.

The difference between the guideline premium test and the cash value accumulation test

The cash value accumulation test (CVAT) and the guideline premium and corridor test (GPT) are two tests that a life insurance contract must pass to be defined as such and receive tax advantages under the US Internal Revenue Code (IRC). The GPT is sometimes referred to as the guideline premium test (GPT) as it has two parts: the guideline premium test and the corridor test.

The CVAT determines whether the premiums paid into a life insurance policy are reasonable in relation to the benefits provided. In other words, it ensures that the policy is not being used solely as a tax shelter. The test looks at the amount of premiums paid into the policy and compares it to the policy's cash value. If the cash value exceeds the premiums required at that time to keep the policy funded, the policy fails the test and may lose its tax-deferred status.

Under the CVAT, a policy must not accumulate cash value too quickly. If it does, it will be considered an investment vehicle rather than an insurance policy, and the policyholder will not be able to take advantage of the tax benefits offered by Section 7702 of the IRC.

The GPT is designed to ensure that a policy remains within certain limits in terms of premiums paid and death benefits received. The GPT caps the premiums that can be paid into a policy to the greater value of either the guideline single premium (GSP) or the total of the guideline annual premiums (GAP) from when the policy was issued. The GSP is the premium that would have to be paid on the day the policy is issued to fund all its future benefits. The GAP is the maximum that can be paid into the policy each year over the life of the contract.

The second part of the GPT, the corridor test, requires a minimum gap, known as the "corridor", between the cash surrender value and the death benefit. This is like the CVAT but the minimum gap is smaller and changes based on the age of the insured person. For example, if the insured person is 40 years old or younger, their policy's death benefit must be at least 250% of their policy's cash surrender value.

The choice of test should be made on a case-by-case basis, with the policyholder giving consideration to how they might want to make premium and death benefit changes in the future. CVAT policies are generally better for policyholders who prioritise the death benefit, while GPT policies are usually better if the policyholder cares more about cash value.

Frequently asked questions