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IRS Tax Code 7702 Plan | How It Affects Life Insurance Policy

IRS Tax Code 7702 (Internal Revenue Service ) sets the guidelines for determining the tax status of whole, universal life, and other types of permanent life insurance.

If a policy does not meet the requirements of code 7702, you may be subject to taxes and penalties on loans and withdrawals you make from the policy’s cash value.

Section 7702 of the Tax Code

Section 7702 seems to be a section of the Internal Revenue Code that limits the amount of premiums one can pay into a life insurance policy without it being considered a taxable investment.

if you pay excess into your policy, withdrawals or loans taken from the cash value could be subject to taxes and penalties – although the death benefit will remain tax-free.

On the other hand, once you stay within the limits set by code 7702, a policy has some important tax-free benefits.

The 7702 tax code requirements are designed to ensure a life insurance policy is primarily for a death benefit pay out and not an investment vehicle.

Under section 7702, a life insurance policy must meet two requirements to qualify for tax-advantaged treatment:

  • The policy must be a “life insurance contract” as defined by the IRS.
  • The policy must pass either the cash value accumulation test (CVAT) or the guideline premium and corridor tests (GPT).
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IRS Tax Code 7702 applies to cash value life insurance policies, not term life insurance policies. See the following section, and find out why the 7702 tax code is important.

Why Is the 7702 Tax Code Important

Are you wondering if your life insurance meets the requirement of Section 7702? You can verify your policy status by contacting your life insurance agent, says Daniel Adams – the founder and president of CEG Life Insurance Services.

Adams also mentions:

When you first purchase a life insurance policy, you can specifically request that your policy remains in compliance with Section 7702

if you ever decide to increase premium payments, Adams recommends that you consult with a qualified insurance agent to determine if there will be an increase that would change your policy’s compliance with Section 7702.

Requirements To Qualify for Section 7702 Tax Code

To stay compliant with IRS Tax code 7702, a life insurance policy must go through one of two tests: the cash value accumulation test (CVAT) or the guide premium and corridor test (GPT).

What if My Life Insurance Policy Doesn’t Meet Tax Code 7702 Guidelines

According to Adams, he says;

While in theory, an indexed universal life (or other cash value) insurance policy could fail the CVAT or GPT, which would then cause it to lose the definition (and tax benefits) of life insurance, in practice life insurance companies will not allow this to happen.

If a policy does not pass its designated test, the insurance company will take steps in order to bring it back into compliance.

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Moreover, Adams gave two examples of what might happen if a life insurance policy doesn’t meet the  IRS tax code 7702 guidelines.

  • If a policy owner chooses the Guideline Premium Test to keep their policy in compliance and then pays an amount of premium that would cause their policy to fail this test, the company would refund the excess premium to prevent the violation.
  • If the client chooses the Cash Value Accumulation Test and the cash value increases to the point that it would violate this test, the company will increase the death benefit amount to keep it in compliance.

Tax Implications of Section 7702

Once your policy is reclassified as an MEC because it fails to comply with section 7702, you lose certain tax-free benefits on distributions.

  • Withdrawals and loans. If you make withdrawals or take loans from an MEC, the amount you receive is generally subject to income tax.
  • Penalties for distributions. If you withdraw funds from an MEC before you reach age 59½, you may be subject to an additional 10% early-withdrawal penalty on top of the income tax.
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Life insurance component Modified Endowment Contract (MEC) Cash value life insurance
Cash value accumulation Tax-deferred Tax-deferred
Death benefit Paid tax-free Paid tax-free
Loans Taxable Not subject to taxes up to “cost basis” (amount paid in premiums)
Withdrawals Subject to 10% penalty if under age 59½ Not subject to taxes up to “cost basis” (amount paid in premiums)

 

Since code 7702 is not a life insurance plan – it’s a tax code, and it’s sometimes called a 7702 plan. Non-compliance with code 7702 alerts a reclassification of a life insurance policy to an MEC.

However, Mec does not have the same tax advantage as cash value life insurance policies. Distributions will come from the interest on your cash first, which indicates that the money you take out of the policy is taxed as regular income.