What Is IRS Code 7702 for Life Insurance Policies?

Internal Revenue Service (IRS) Code Section 7702 defines a life insurance contract for federal tax purposes. Enacted in 1984, this regulation distinguishes between policies that offer insurance protection and those that function more like investment vehicles. Policies that meet the criteria in Section 7702 receive favorable tax treatment, while those that do not are taxed like other investments.

The code was introduced to prevent the misuse of life insurance policies as tax shelters, as the previous rules allowed products to be structured as life insurance primarily to avoid taxes on investment gains. Section 7702 applies to cash value life insurance policies issued after 1984. For policies issued after 2020, the Consolidated Appropriations Act of 2021 amended interest rate calculations, replacing fixed rates with variable rates that are updated annually. This change allows for larger premiums relative to the death benefit in modern policies.

The Life Insurance Qualification Tests

To qualify as a life insurance contract under Section 7702, a policy must satisfy one of two tests: the Cash Value Accumulation Test (CVAT) or the Guideline Premium and Cash Value Corridor Test (GPT). These tests measure whether a policy maintains a sufficient level of insurance risk relative to its investment component. Insurance companies design their products to comply with one of these tests, and the choice impacts the policy’s premium flexibility and cash value growth potential.

Cash Value Accumulation Test

The Cash Value Accumulation Test (CVAT) is a forward-looking assessment that must be met for the entire life of the policy. It stipulates that the policy’s cash surrender value can never exceed the “net single premium” required to fund its future death benefit. The net single premium is the one-time, lump-sum payment that would be sufficient to fully pay for the policy’s death benefit, based on specified assumptions.

This test creates a ceiling for the cash value, ensuring it does not grow too large in relation to the death benefit. The CVAT is used for policies like whole life insurance, where the goal is to maximize the death benefit over cash accumulation. The test is applied at the time of issue and must hold true for the contract to remain compliant.

Guideline Premium and Cash Value Corridor Test

The Guideline Premium and Cash Value Corridor Test (GPT) is a two-part evaluation providing more flexibility for premium payments. The first part, the guideline premium limitation, restricts the total premiums that can be paid into the contract. This limit is based on either a “guideline single premium” or the sum of “guideline level premiums,” and cumulative premiums paid cannot exceed it.

The second part is the cash value corridor, which mandates that the death benefit must always be a certain percentage higher than the cash value. This corridor of insurance protection ensures a minimum amount of risk for the insurance company. The required percentage decreases as the insured gets older, and this test is chosen for universal and variable universal life policies where policyholders desire more flexibility.

Tax Implications of a Compliant Policy

When a life insurance policy meets the standards of Section 7702, it receives three tax advantages unavailable to non-compliant policies or other investment products.

A primary benefit is the tax-deferred growth of the policy’s cash value. As the cash value earns interest or investment returns, those gains are not subject to annual income tax. This allows the value to compound more efficiently than in a taxable investment account.

Policyholders can also access the accumulated cash value on a tax-advantaged basis. Withdrawals are generally treated as a tax-free return of premiums paid (the policy’s cost basis) first, with further distributions considered taxable gains. Policy loans are also typically received income tax-free, provided the policy remains in force and is not a Modified Endowment Contract (MEC).

The most well-known tax advantage is the income tax-free death benefit. Upon the death of the insured, the proceeds paid to beneficiaries are generally not subject to federal income tax. This ensures the full benefit is transferred to the heirs without being diminished by taxes.

Consequences of Failing the Qualification Tests

If a life insurance policy fails to meet either the CVAT or the GPT, it loses its status as a life insurance contract for tax purposes and faces negative tax consequences. The IRS then treats the policy as an investment vehicle, altering how its growth and distributions are taxed. This failure occurs if too much premium is paid into the policy relative to its death benefit, causing it to be overfunded.

Taxation During the Policyholder’s Life

Once a policy is non-compliant, its tax-deferred growth is eliminated. The “income on the contract” becomes taxable to the policyholder as ordinary income for that year and every subsequent year. This income is calculated as the annual increase in the policy’s net surrender value, plus the cost of life insurance protection, minus the premiums paid during that year.

The policyholder must report and pay taxes on the internal gains annually, even if no money is withdrawn. The policy effectively becomes a taxable investment account, and any loans or withdrawals may also have different tax implications.

Taxation of the Death Benefit

Failing to comply with Section 7702 also changes the tax treatment of the death benefit. For a failed policy, only the portion of the death benefit that exceeds the policy’s net surrender value at the time of death is tax-free to the beneficiary. The portion of the benefit equal to the net surrender value is taxable as ordinary income, which can result in a tax liability for the beneficiaries.

Correcting a Non-Compliant Policy

When a life insurance policy inadvertently fails to meet Section 7702 requirements, the IRS provides a path for correction. This process allows an insurance company to remedy the error and restore the policy’s tax status, provided the failure was due to a reasonable error. The mechanism for this is a formal closing agreement with the IRS.

The responsibility for identifying and correcting a non-compliant policy rests with the insurance company. The insurer must take steps to bring the policy back into compliance, which involves either increasing the death benefit or distributing excess premiums back to the policyholder. These corrective actions must be completed within a specific timeframe after executing the closing agreement.

As part of the correction process, the insurer must pay a toll charge to the IRS. This payment is calculated based on the earnings associated with the non-compliance. In return for the insurer’s corrective actions and payment, the IRS will agree to treat the policy as if it had been compliant from its inception.