What Is a 702(j) Retirement Plan?

When you’re researching ways to fund your retirement, you might come across something that goes by one of these names:

702(j) plan

7702 plan

7702 private plan

Infinite Banking Concept®

Bank on Yourself®

Become Your Own Bank

High cash value life insurance

Those selling these goods or techniques claim that they give returns that are 40 to 60 times better than the earnings on cash in your bank account—which isn't hard to believe when bank accounts pay 0.01 percent interest. They also claim to provide a solution for you to borrow money for large purchases without having to go via a lender. They also claim that the vehicles are a form of hidden account that the government doesn't want you to know about, but that important politicians, billionaires, and bankers are pouring their own money into—a claim that is exceedingly dubious.

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So, should you immediately log into your brokerage account and initiate a 702(j)? No, you can't do it—but it's not because the government is preventing you from doing so. There is no such thing as a 702(j) account, and you cannot open one through your employer, bank, or brokerage.

However, your friendly insurance agent or financial planner can sell you one. A 702(j) plan is simply a marketing phrase for a permanent life insurance policy covered by US Code section 7702. According to Samuel R. Price, an independent broker with Assurance Financial Solutions who provides life, disability, and long-term care insurance, “insurance brokers have utilized this term and topic a great deal over the past few years to induce customers to acquire permanent life insurance.”

To understand how all this relates to retirement and savings plans, read on.

KEY TAKEAWAYS

• 702(j) plans are essentially permanent life insurance policies governed by section 7702 of the U.S. Code.
• Although it can be used for retirement income, it’s not the best option for most people, and shouldn’t be their sole option.
• A 7702 policy is really a loan against the cash value of a policy, so it's not counted or taxed as income.
• Policyholders can't withdraw 100% of the cash value, because doing so causes it to lapse.

A Misnomer Is the 702(j) Plan

Let's start by defining these words. We mean this when we claim there is no such thing as a 702(j) plan: There is no section 702(j) of the tax code that refers to retirement plans or tax-deferred savings, unlike 401(k), 403(b), or 457(b) plans, which are called after their corresponding sections of the tax law.

The tax code contains numerous section 702s (in titles 5, 15, 17, 32, 33, and 44, for example). Even in chapter 15 of title 33, there's a section 702(j) that deals with projects involving tributary waterways. However, there is no investment-related section 702(j) of the tax code.

Section 7702 of the United States Code, which codifies all of the United States' general and permanent laws, deals with the tax treatment of insurance products. To be more explicit, we're talking about Section 7702 of Title 26, Subtitle F, Chapter 79. Section 7702(j) deals with "some church self-funded death benefit plans treated as life insurance."

Plans in Section 702(j) are insurance policies

These 702(j) plans are based on Section 7702 of the Internal Revenue Code. They are, in essence, permanent life insurance policies that are controlled by that part of the United States Code. It's unclear why one of the "7"s is eliminated and where the "j" comes from—possibly to make the vehicle sound more like a 401(k) or 403(b) plan (b).

According to financial consultant and counselor Richard Sabo, founder of RPS Financial Solutions and insurance industry whistleblower, calling a policy a 702(j) plan is "a nice technique to dress up life insurance" for whatever purpose. “Because life insurance is one of the greatest commission items in the market, it's been sold as a variety of things for years, but it's just life insurance."

Permanent life insurance, whether whole life, variable life, or universal life, that builds up a tax-free cash value that policyholders can borrow against is not a novel notion. Is it possible to use a section 7702 insurance policy to supplement your retirement income? Absolutely. However, it isn't the best option for most individuals, and it shouldn't be the only option for anyone.

A 7702 Insurance Policy's Advantages

The majority of Americans do not contribute the maximum annual amounts allowed to their retirement savings accounts, and one-third of all individuals in the United States have no money set up for retirement. Let's imagine, on the other hand, you're maxing out your retirement funds every year. What more could you do to save money in a tax-advantaged manner?

A 7702 insurance coverage could be an excellent choice. It's also a good idea for people who are concerned about the tax implications of required minimum distributions (RMDs) from traditional IRAs and 401(k)s, paying tax on Social Security income, or paying Medicare Part B premium surcharges. The 2021 Part B standard monthly premium is $148.50, with a $203.11 annual deductible for those enrolled, according to the Centers for Medicare & Medicaid Services (CMS). Some of these issues have an impact on the middle class, particularly the upper middle class. They do, however, have an impact on the wealthy.

A 7702 policy provides what’s called tax diversification. It provides a source of income that is not counted as income or taxed as income because it’s really a loan against the cash value of your policy.

Another advantage, according to Price, is that "permanent life insurance can be a hedge against a negative sequence of returns," allowing a policyholder to withdraw money from their policy in years when their traditional investments have performed poorly and it isn't the best time to liquidate them for income.

However, you must obtain a well-crafted policy from a reputable insurance company and understand how it operates.

How Does a 7702 Policy Get Funded?

Premiums are paid in exchange for coverage when you purchase any sort of life insurance. Almost all of your premium money go toward insurance when you buy term life insurance, vehicle insurance, or homeowners insurance, with a little percentage going toward the insurance company's running costs.

When you buy permanent life insurance, a portion of your premiums goes toward the cost of insurance (which provides your heirs with a death benefit), a portion goes to sales commissions (which compensate the broker or agent who sold you the policy), and a portion goes to the insurance policy's cash value, which is similar to a savings or investment account attached to an insurance policy. To be clear, the cash value account is neither a savings nor an investment account (see more on this topic in the next section). Although it appears to be your money, the insurance company keeps it when you die. It will not be distributed to your intended recipients.

Let's take a closer look at premiums. 

Permanent life insurance can give you more options when it comes to the amount of premium you must pay. Instead of paying monthly or annual rates, you could pay a single large payment up front (this is called single premium life insurance). Your policy would be completely funded at that point. On the other hand, you might pay the bare minimum, the minimal amount necessary to keep your policy active.

A 7702 policy falls somewhere in the middle of those two extremes. You pay premiums for a period of time, maybe seven to twelve years, but you pay more than the minimum. Your insurance will accumulate cash value slower than if you paid a single premium payment, but faster than if you paid those premiums over a 30-year period. Many people cannot or do not want to pay a hefty one-time premium; instead, they want to pay monthly or annually as they earn money.

Over those seven to twelve years, you can't afford to pay too much in premiums. What constitutes "too much?" It's tricky, but if you pay too much, the tax code considers your policy to be a modified endowment contract rather than insurance (MEC). Taxes and penalties may be imposed on MEC disbursements.

How to Get Cash Out of a 7702 Policy

You can borrow money from your 7702 policy's cash value if you need money in retirement or at any other time. The cash value of your policy, like the cash value of a 401(k) or IRA, grows tax-deferred. However, unlike other types of accounts, when you withdraw money from a 7702 policy, you don't have to pay income tax, and there's no penalty for withdrawing money before reaching the age of 5912.

However, because this is a loan, you must pay interest on the amounts you withdraw. In today's relatively low-rate climate, interest rates could range from 1% to 6%, depending on the policies.

You also need to be cautious about how much money you borrow. You can't take out all of the cash value because the coverage will lapse if you do so. A gap is a major issue since it results in a large tax payment from "phantom income," as described by Chris Acker, a term life insurance agent. In a perfect world, the insurance provider would not allow you to borrow more than 90% of the cash value and would have protections in place to prevent your policy from lapse.

“Consumers should be very careful when choosing a permanent insurance business because if the policy terminates due to collecting too much of the cash value, taxes on years of accumulation may be owed,” Price warns. “Some insurance firms are better than others, and they construct plans with over-loan protection, which prevents the policyholder from withdrawing too much money from the policy. Others are less than ideal, failing to notify policyholders when their insurance is set to expire.”

As Sabo goes on to explain, if you keep taking out loans on the insurance and paying loan interest, your loan value could eventually equal your cash value, causing the policy to lapse. Then all of those loans are taxed at the same time. He adds that ensuring the loans are actual tax-free disbursements is "extremely challenging." The policy will only be fully tax-free if you hold it until you die, at which point any outstanding loans and interest will be deducted from the death benefit.

As a result, using a 7702 policy as a retirement vehicle is not a smart strategy to pay a death benefit to your heirs. Its goal is to allow you to borrow against the cash value of your policy while you're still living.

A Good 7702 Policy's Characteristics

The issue with using 7702 life insurance in this fashion, according to Acker, is that “everything needs to go right: the dividends have to pay properly, the loan has to be constructed right, and it has to be serviced and illustrated right.” The policy's effectiveness depends on how well it is serviced.

According to him, the insurance firm must ensure that the client repays the loans on time. The insurer also ensures that you don't overfund the policy, which would turn it into a MEC (as noted above) and eliminate the tax benefits you're looking for. That would be in direct opposition to the goal of a "702(j) plan," which is to provide a tax-free source of retirement income.

In addition to "direct recognition," a good 7702 policy will include "non-direct recognition." Whether you have borrowed money from your policy's cash value or not, you will get the same dividends with non-direct recognition. Because the whole point of buying life insurance for retirement income is to borrow money from the cash value, you don't want a policy that reduces payouts when you take a policy loan.

What about your cash value's tax-free growth? 

When the markets are performing well, a 7702 policy not only pays you a rate of return, but it also doesn't lose money when the markets are doing poorly. Your downside is restricted, but your upside is as well. A solid insurance will have a high upside potential, allowing you to profit more during a bull market. But it's only natural that if you're going to minimize your losses, you're also going to limit your gains.

The Negative Effects of 7702 Policies

Even if you have a decent 7702 policy, you will still have to pay commissions and fees, which are one of the most significant disadvantages of permanent insurance. “There are upfront expenses like sales loads, monthly expense charges, insurance costs, and other fees that stifle the growth of the cash value,” Sabo explains.

“When you contribute to a 401(k), 100% of your money goes into it and is invested. Although the underlying assets may incur certain expenses, your money is fully invested.” “If you put money into a life policy, they take a sales charge off the top, they charge a monthly administrative charge, and then there's the cost of insurance,” Sabo continues. So, how can it be such a good investment if you're going backwards before you've even begun?”

Assume you're willing to pay those charges. Is the insurance provider willing to detail how much of your premiums goes toward these expenses? You may want to give your premium cash to a company that is upfront and gives you with accurate numbers.

What else could you buy with the money that goes to the insurance company's overhead? Are the expenditures of obtaining the benefits of a 7702 worth it to you in your situation? That's a question only you can answer—ideally with the help of a fiduciary financial advisor who isn't attempting to sell you anything other than advice and is legally obligated to put your needs ahead of their own. If you're wealthy, you'll want an advisor that specializes in assisting high-net-worth individuals.

The Bottom Line 

A 702(j) plan is simply a marketing name for a permanent life insurance policy covered by US Code section 7702. These insurance policies are not scams, but they are only suitable for a tiny group of wealthy people who have exhausted all other options for their extra cash. Even yet, these plans have a variety of complexity and hazards that potential policyholders must be aware of.

Furthermore, paying commissions and fees to an insurance company for the privilege of being able to borrow their own money with interest—even if that money grows tax-free—does not make sense for most individuals.

For the most part, fully financing IRAs and employer-sponsored retirement accounts is the greatest method to "bank on yourself." Traditional and Roth IRAs are the most popular retirement plans. For individuals ready to take on the risk of a high-deductible health insurance policy, an HSA is another viable choice.