What Is a 7702 Plan? Life Insurance Tax Rules Explained

Section 7702 of the Internal Revenue Code establishes the criteria for life insurance policies to qualify for traditional tax advantages. While “7702 plan” refers to a policy meeting these IRS guidelines, it’s not a distinct product. These guidelines apply primarily to cash value life insurance policies, including whole life, universal life, variable universal life, and indexed universal life.

Defining Section 7702

Section 7702 defines what constitutes a legitimate life insurance contract for federal tax purposes. Its purpose is to differentiate genuine life insurance from investment vehicles, ensuring policies maintain a true insurance component and provide a death benefit, rather than serving solely as tax-sheltered savings accounts.

Before Section 7702, federal tax law was less stringent. Death benefits were income tax-exempt, and gains within a policy were not taxed. By the early 1980s, some individuals used life insurance primarily as investment vehicles with minimal insurance risk.

To prevent life insurance from becoming a tax shelter, Congress introduced Section 7702 as part of the Deficit Reduction Act of 1984. The legislation established criteria policies must meet to retain tax-advantaged status, ensuring contracts are structured for financial protection and risk shifting.

Section 7702 applies to life insurance contracts issued after 1984. If a policy fails to meet these requirements, both the cash value growth and the death benefit may become taxable as ordinary income. This framework guides the design of cash value life insurance products for compliance.

Core Features of 7702-Compliant Life Insurance

Life insurance policies complying with Section 7702 have two main components: the death benefit and the cash value. The death benefit provides a sum to beneficiaries upon the insured’s death, serving as financial protection against mortality risk.

The cash value, found in permanent policies, accumulates as premiums are paid. A portion of each premium covers insurance costs and fees, with the remainder contributing to this cash value. It grows based on interest, dividends, or investment returns, depending on the policy type.

For a policy to comply with Section 7702, the relationship between the death benefit and cash value is important. The code ensures the death benefit remains substantial relative to the cash value, preventing the policy from functioning predominantly as an investment. This balance helps the policy be recognized as a legitimate life insurance contract for tax purposes.

Premiums paid into a 7702-compliant policy fund both the death benefit and cash value growth. This dual allocation is part of the policy’s structure and its ability to meet the statutory definition of life insurance. The design provides a meaningful death benefit while allowing for tax-deferred cash accumulation.

Maintaining 7702 Compliance

To qualify and maintain status under Section 7702, a policy must satisfy one of two tests: the Cash Value Accumulation Test (CVAT) or the Guideline Premium Test (GPT). These tests ensure the policy remains insurance, not an investment. The choice is made at issuance and cannot be changed.

The Cash Value Accumulation Test (CVAT) focuses on the policy’s cash value relative to future benefit costs. Under CVAT, the cash surrender value cannot exceed the net single premium required to fund future benefits. If the cash value exceeds this limit, the policy fails the test and loses its tax-advantaged status.

The Guideline Premium Test (GPT) has two components: a premium limitation and a cash value corridor. The guideline premium limitation restricts total premiums paid, preventing overfunding that could make the policy resemble an investment. Premiums cannot exceed this limitation, which is based on a guideline single premium or annual premiums.

The Cash Value Corridor requires the death benefit to maintain a specified relationship to its cash value. The death benefit must be at least a certain percentage of the cash surrender value, decreasing as the insured’s age increases. For example, a younger policyholder might need a death benefit 250% of the cash value, ensuring pure insurance risk. This corridor prevents the policy from becoming overly cash-heavy, preserving its life insurance classification.

Taxation of 7702 Policies

Policies complying with Section 7702 receive specific tax treatment. One advantage is the tax-deferred growth of the cash value. Earnings, such as interest or investment gains, accumulate without current income tax. Policyholders do not pay taxes on these gains as they occur, allowing the cash value to compound efficiently.

The death benefit paid to beneficiaries is income tax-free. This means recipients receive the full face amount without income tax deductions. This tax-free nature of the death benefit is preserved under Section 7702.

Policyholders can access cash value during their lifetime, often tax-free, through withdrawals or policy loans. Withdrawals are tax-free up to the amount of premiums paid (cost basis). Amounts exceeding this basis, representing gains, would be subject to income tax.

Policy loans are another way to access cash value and are not taxable income, provided the policy remains in force. These loans use the cash value as collateral, and interest may accrue. If a policy lapses or is surrendered with an outstanding loan, the untaxed portion may become taxable.

If a policy becomes a Modified Endowment Contract (MEC) due to excessive premium funding, its tax treatment changes. MECs lose some tax advantages, particularly regarding cash value distributions, which are subject to “last-in, first-out” (LIFO) taxation and may incur penalties on gains if accessed before age 59½.