Section 7702 is an IRS tax law that explains whether life insurance enjoys tax status. When purchasing life insurance, it is useful to know whether there is tax on the cash value of the insurance policy and death benefits. Bankrate’s insurance teams provide detailed explanations in Section 7702 guidelines, allowing you to understand the value and tax expectations of insurance contracts.
What is Section 7702?
It is often referred to as “7702 plan,” but the term is not a real type of insurance policy, but a marketing concept. Section 7702 of the IRS Tax Act defines the criteria that cash value life insurance contracts must meet to recognize tax benefits. There are two main types of life insurance: term life insurance and permanent life insurance. Only permanent life insurance, such as lifetimes and universal life, can accumulate cash value. Section 7702 applies specifically to these cash value policies.
The tax law sets up multiple tests that these policies must pass to maintain their tax status.
- Cash Value Accumulation Test (CVAT): This test ensures that the policy’s cash surrender value does not exceed the amount required to fund future profits. Simply put, the cash value of a policy must remain within the limits set by the IRS.
- Guideline Premium and Corridor Test (GPT): This is a two-part test. Guideline Premium Testing ensures that your insurance policy will not exceed the maximum amount allowed to qualify as life insurance. Hallway tests require that death benefits be well above the cash value to meet IRS guidelines.
It will help you understand these two tests better.
- CVAT ensures that the amount of cash you get from cancelling your policy is not greater than what is necessary to pay for future benefits of your policy.
- The GPT ensures that you are not paying the policy more than necessary, and that the death benefit is always significantly higher than the policy’s cash value.
If your life insurance does not meet these criteria, the revenues may be taxed as normal income. Understanding section 7702 helps policyholders know how the cash value of their policy grows and which tax benefits are available. Although these policies are not retirement plans, policyholders can usually borrow against cash value and withdraw for a variety of purposes, including retirement. However, it is important to understand the rules of such withdrawal and the potential tax implications.
What is the Cash Value Accumulation Test (CVAT)?
CVAT is one of the tests defined in section 7702. This test ensures that the cash value of your life insurance does not exceed the net single premium required to purchase the policy entirely based on its death benefit. In other words, cash value should not be higher than what you paid in a lump sum to purchase the policy, except for fees, if you maintain your tax status. If your insurance policy passes CVAT, you are eligible as a life insurance policy for income tax purposes.
For example, if you have life insurance, CVAT will ensure that the cash value you can receive if you cancel your policy is not just a single payment you need to purchase the policy in advance. Insurance that uses CVAT typically includes life insurance. These policies accumulate cash value over time, and CVAT ensures that this cash value remains within the limits set by the IRS. By meeting this test, policyholders can benefit from the tax benefits associated with true life insurance.
What is Guideline Premium and Corridor Test (GPT)?
GPT determines whether life insurance qualifies for tax benefits in a two-part test, as defined in Section 7702.
- Guideline Premium Test: This part of the test limits the amount of premiums you can pay in the policy at any time. Limitations vary based on the insurance company’s fees and claim experience. Essentially, policyholders guarantee that they don’t pay more than they need to pay for the policy to be considered life insurance.
- Hallway Test: This part of the test requires that the policy’s death benefit always exceed a specified multiple of its cash value. This multiple depends on the age of the insured. If the cash value exceeds this corridor, the insurance contract is considered to be overfinanced and is classified as an amended fund contract (MEC) that will lose the tax benefits associated with life insurance.
To remove jargon and simplify these concepts further:
- Guideline Premium Testing will help you avoid putting too much money in your policy. Limitations depend on the insurance company’s costs and experience.
- Hallway testing ensures that death benefits are always far higher than the policy’s cash value. This multiple varies depending on your age. If cash value is too high, the policy is considered over-finance and loses tax benefits.
- The hallways become narrower as you get older. This allows the policy to be mature.
Insurance that often uses GPT includes universal life insurance. These policies allow for flexible premiums and can accumulate cash value. GPT ensures that insurance remains within the limits set by the IRS and maintains its status as a life insurance policy with associated tax benefits.
Why is Section 7702 important?
Section 7702 is an important part of the IRS tax law. This is to define whether cash value life insurance covers tax benefits. If the policy does not meet the requirements outlined in this section, both the policy’s cash value growth and death benefits could be taxed as normal income. Fortunately, most life insurance today complies with these rules, so policyholders usually don’t have to worry about losing their tax benefits.
The origin of Section 7702 goes back to concerns about tax avoidance. In the early days of life insurance in the US, insurance was designed to help widows and children. By 1984, however, some wealthy individuals were using these tax-free benefits by using life insurance as an investment vehicle rather than the intentional purpose of providing financial protection. To address this, Congress introduced Section 7702, establishing specific criteria that life insurance policies must meet to maintain their tax position. This will ensure proper use of life insurance and prevent misuse as a tax shelter.
How Section 7702 Planning Works
There is no specific “Section 7702 Plan.” Instead, Section 7702 refers to the IRS guidelines that life insurance must meet to maintain its tax status. These guidelines apply to a variety of types of cash value life insurance, including lifetime, universal life, various universal life, indexed universal life.
Here’s how these policies typically work:
- Accumulation of cash value: The cash value of a policy accumulates over time based on premiums paid and the potential investment revenue, dividends, or interest loaned to the policy.
- Tax Deferred Growth: Cash value increases on a tax deferred basis. This means that as long as it remains within the Section 7702 guidelines, you do not need to pay taxes on growth. Tax codes are subject to change, so we recommend working closely with your agent to provide information.
- Death benefits: This is the amount paid to the beneficiary upon the death of the insured. Under Section 7702, death benefits are generally tax-free.
- Access to cash value: Policyholders can access cash value through withdrawals or policy loans. Withdrawals are usually tax-free to the amount of premiums paid (owner’s basis). Policy loans are generally tax-free as long as the policy remains active, but incur interest that can affect the policy’s cash value and death benefits.
The amount of cash value accumulated within a policy will vary depending on the type of policy and the amount paid over time. Various policies have the potential for higher growth in the long term, but may also reduce their value as the market declines. Indexed Universal Life Policies tend to be safer as they are guaranteed to prevent the policyholder’s cash value from falling if the associated indexes are performing poorly. However, there are trade-offs to potential returns. They usually have a lower chance of long-term growth compared to different policies.
