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
Some people marketing these ideas say they provide returns 40 to 60 times higher than you earn from the cash sitting in your bank account (which isn’t hard when bank accounts pay 0.01% interest) and that they give you a way to borrow for major purchases without having to qualify through a lender (true). They also say that these are a secret type of account that the government doesn’t want you to know about but that major political figures, billionaires and bankers are pouring their own money into (highly questionable).
So should you sign into your brokerage account right now and open up a 702(j)? Nope. It’s impossible to do that. But it’s not because the government is keeping you from doing so.
702(j) Plans Are a Type of Insurance
Supporters of so-called 702(j) plans will take issue with critics who say they aren’t plans at all, but insurance policies. They’ll say that a 401(k) plan isn’t really a plan either, but a special type of account. We’re not here to quibble over semantics. Let’s just say 702(j) is a misleading marketing term.
“Insurance agents have used this term and topic a great deal over the past few years to convince people to buy permanent life insurance,” says Samuel R. Price, an independent broker with Assurance Financial Solutions in Birmingham, Ala. AFS sells life, disability and long-term care insurance.
Unlike the 401(k), 403(b) or 457(b), which are named after their respective sections of the tax code, there is no section 702(j) of the tax code that deals with retirement plans or life insurance.
There is a section 7702, which deals with the tax treatment of insurance products. And there is a section 7702(j), but that deals with “Certain church self-funded death benefit plans treated as life insurance.” And to be more specific, we’re talking about Title 26, Subtitle F, Chapter 79, Section 7702. There’s actually more than one section 7702 in the United States Code. There are also several section 702s within the tax code (in titles 5, 15, 17, 32, 33 and 44, for example); there’s even a section 702(j) in chapter 15 of title 33 that deals with projects relating to tributary streams.
Here is why you can’t open up a 702(j) account through your employer, your bank or your brokerage: because there’s no such thing.
What you can do is buy a permanent life insurance policy – whole life, variable life or universal life – through an insurance agent or broker, a policy whose tax treatment is governed by section 7702 of the United States Code.
Calling this policy a 702(j) is “a fancy way to dress up life insurance because no one wants to buy it,” says financial consultant and advisor Richard Sabo, the founder of RPS Financial Solutions and a proud insurance industry whistleblower. “You have to understand that life insurance is one of the highest commission products in the industry, and therefore people have been selling it as all kinds of things for years, but it is just life insurance.”
A life insurance policy is a contract between you and an insurance company, not a savings or investment account. Specifically, it is a participating policy, which means that it pays dividends to its policyholders. Dividends can be cashed out, placed in a savings account with the insurance company, used to help pay policy premiums or used to purchase more insurance. To get a policy that pays dividends, you must buy your policy from a mutual insurance company, which is owned by its policyholders, not from an insurance company that is owned by its shareholders.
Permanent life insurance that accumulates cash value that policyholders can borrow against is not a new concept. Can you use a section 7702 insurance policy for retirement income? Absolutely. But it’s not the best option for most people, and it shouldn’t be anyone’s only option.
A Policy for the Wealthy
The wealthy have unique tax challenges, and they need unique solutions to those challenges. If you are not wealthy, you have a different set of tax challenges that requires different solutions. Trying to use a wealthy person’s tax-reduction strategy will not make you wealthy.
Most Americans are not maxing out their retirement-savings accounts, and one-third of American adults have nothing saved for retirement. But let’s say you are maxing out your retirement accounts every year. What should you be doing with the extra cash?
Most financial experts would probably tell you to use the money to pay down debt, save money in a 529 plan for your kid’s education, max out your health savings account (if you have one) or put it in a taxable brokerage account – maybe in an investment like municipal bonds, where your returns are not taxable.
They might tell you to make sure you have enough term life insurance to protect your dependents; enough homeowners, natural disaster, car and liability insurance to protect your property and your savings; and long-term care insurance to protect against health challenges related to longevity. And, especially if you are affluent and able to handle the risk of having a high-deductible health insurance policy, you might open a health savings account if you don’t have one and max out on its tax-protected retirement savings opportunities.
If you still have extra cash, you might buy a bigger house or purchase an investment property or two. You might set up trust funds for your children, nieces and nephews. You might invest in a private company or a hedge fund. If you own a business, you can put a good chunk of change into a self-employed 401(k). You can also reinvest in your business.
But what if you’re already doing all of those things that are relevant to your circumstances and you still have more cash to invest? Then a 7702 insurance policy might be a good option. It might even be a good option before you start venturing into alternative investments like private equity, real estate and hedge funds. But you have to get a well-constructed policy from a top-notch insurance company and you have to understand how it works.
Some people, for example Chris Acker, a term life insurance agent based in Redwood City, Calif., will tell you that no one should buy it, “because life insurance policies inherently have huge fees. No one typically gets rich on a life insurance contract,” he says, acknowledging that this is a pretty contentious issue. His view is that “if you don’t need a death benefit, you shouldn’t be buying life insurance, period.”
A 7702 policy might make sense for people who are worried about the tax consequences of required minimum distributions (RMDs) from traditional IRAs and 401(k)s, paying tax on their Social Security income or paying Medicare Part B premium surcharges. Some of these concerns affect the middle class, especially the upper middle class. But they definitely affect 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 potential benefit, as Price explains, is that “permanent life insurance can be a hedge against a negative sequence of returns letting a policyholder draw cash out of their policy in years where their traditional investments have done poorly and it isn’t the optimum time to liquidate them for income.
How Funding a 7702 Policy Works
First and foremost, insurance is something you have to qualify for. Your health determines whether you can obtain coverage and at what price. But for the purposes of this article, let’s assume you qualify.
When you buy any type of life insurance, you pay premiums in exchange for coverage. When you buy term life insurance, car insurance or homeowners insurance, almost all of your premium dollars go toward insurance, with some percentage going toward the insurance company’s operating costs.
When you buy permanent life insurance, part of your premiums goes toward the cost of insurance (which is what provides a death benefit for your heirs), part of them goes to sales commissions (which compensate the broker or agent who sells you the policy) and part of them goes to the insurance policy’s cash value, which is sort of like a savings or investment account attached to an insurance policy. But, to be clear, cash value is not actually a savings account or an investment account (see more on it in the next section). It seems like it’s your money, but when you die, the insurance company keeps it. It will not go to your heirs.
Let’s go more in-depth on premiums. Permanent life insurance can offer flexibility in the amount of premium you’re required to pay. Instead of paying monthly or annual premiums, for example, you could pay one big premium at the beginning (this is called single premium life insurance). Your policy would then be fully funded. At the other extreme, you could pay the minimum, the smallest amount that will keep your policy in force.
With a 7702 policy, you do something in between those two extremes. You pay premiums for several years, perhaps 7-12, but you pay more than the minimum. By doing so, your policy accumulates cash value slower than it would if you made a single premium payment, but faster than it would if you spread those premiums over, say, 30 years. Lots of people can’t or don’t want to pay a large single premium; they want to pay monthly or annually as they earn money from working.
What you can’t do is pay too much in premiums over those 7-12 years. What’s “too much?” It’s complicated, but if you pay too much, the tax code says your policy is no longer insurance, but a modified endowment contract (MEC). At this point, it doesn’t fulfill the purpose of a “702(j)” policy, which is to provide an additional source of retirement income.
How to Withdraw Money from a 7702 Policy
If you need money in retirement – or at any other point – you can get it by borrowing from your 7702 policy’s cash value. Like a retirement account, such as a 401(k) or IRA, the cash value of your policy grows tax deferred. But unlike those types of accounts, when you take money out of a 7702 policy you don’t pay income tax, and there’s no penalty for taking money out before age 59½. But then, loan proceeds are typically not taxable (unless you default on a loan and the lender or debt collector forgives your balance).
What you do pay on a loan is interest, and 7702 policy loans are no exception. Interest rates in today’s relatively low-rate environment might range from 1% to 6% depending on the policy.
And you have to be careful about how much you borrow. You can’t borrow 100% of the cash value, because doing so will cause the policy to lapse. A lapse is a big problem because it creates a huge tax bill from what Acker calls “phantom income.” Ideally, the insurance company will not allow you to borrow more than 90% of the cash value and will have safeguards in place to prevent your policy from lapsing.
“Consumers need to be very careful in selecting their insurance company for permanent insurance, since if the policy lapses from taking too much of the cash value, taxes can be owed on years of accumulation,” Price says. “Some insurance companies are better than others and build policies with over-loan protection that guards the policyholder from taking too much cash out of the policy. Others are not so good and do not forewarn the policyholder when their policy is about to self-destruct.”
As Sabo further explains, if you are constantly taking out loans on the policy and being charged loan interest, your loan value could get as high as your cash value, and that’s when the policy lapses. Then, all those loans become taxable at one time. It is “very tricky” to make sure the loans are true tax-free distributions, he adds. The only way for the policy to be truly tax free is if you keep the policy until your death, at which time the outstanding loans and interest are subtracted from the death benefit.
For this reason, a 7702 policy that you want to use as a retirement vehicle is not a good way to provide a death benefit for your heirs. Its purpose is to allow you to borrow against the policy’s cash value while you’re alive. You need a separate policy, either a term policy or a permanent policy whose cash value you will leave alone, if you want to make sure your heirs will receive a specific sum when you die.
Characteristics of a Good 7702 Policy
Acker, who has more than 30 years of experience in the insurance industry, said that where the rubber really meets the road is in the servicing of a 7702 policy. He notes that the insurance agent’s commission is based heavily on selling the policy, not on keeping it in force. Servicing the policy well is essential to its effectiveness, but this process is labor intensive, provides little compensation to the agent and may not even be something the agent knows how to do.
The problem with this type of policy, Acker explains, is that “everything has to happen the right way: The dividends have to pay the right way, the loan has to be structured the right way, and it’s got to be serviced and illustrated the right way.” The insurance company also needs to make sure the client pays back the loans on a schedule, he says.
A good 7702 policy will also have what’s called “non-direct recognition” as opposed to “direct recognition.” You want your policy to have non-direct recognition because if it does, you will earn the same dividends whether you have borrowed money from your policy’s cash value or not. Since the whole purpose behind the strategy of using life insurance for retirement income is to borrow money from the cash value, you don’t want a policy whose dividends decrease when you take a policy loan.
Another aspect of a good policy, as mentioned earlier, is that the insurer makes sure you don’t overfund the policy, which would cause it to be a MEC and therefore lose the tax advantages you’re seeking. MEC distributions are subject to taxes and possibly penalties.
What about the tax-free growth of your cash value? What makes it grow? A 7702 policy not only gives you a rate of return when the markets are doing well, but it doesn’t lose money when the markets are doing poorly. Your downside is limited – but so is your upside. A good policy will have a relatively high upside so you can benefit more during a bull market. But it only makes sense that if you’re going to have limited losses, then you’re also going to have limited gains. Some people are fine with this trade-off, even if they might end up with less money in the long run, because they aren’t comfortable taking on too much risk. Everyone’s risk tolerance is different, and that’s an important component of any decision to save, invest or buy insurance.
The Downside: Commissions and Fees
Even if you have a good 7702 policy, you’re still paying those commissions and fees, which are one of the biggest drawbacks to any type of permanent insurance.
“There are upfront charges such as sales loads, monthly expense charges and the cost of insurance as well as various fees which stunt the growth of the cash value,” Sabo says.
“If you put money in a 401(k), then 100% of your money goes into it and is invested. The underlying investments may have some expense charges, but your money is being fully invested.” By contrast, Sabo further explains, “if you put money into a life policy, they take a sales charge off the top, they charge a monthly administrative charge and there is the cost of insurance. Therefore, how is it such a great investment if you are going backwards before you even start?”
Let’s say you’re willing to pay those fees. Is the insurance company willing to break down exactly how much of your premiums is going toward those costs? It probably won’t be, but a company that’s transparent and providing you with honest numbers may be a company you actually want to give your premium dollars to.
Still, what else could you buy with the money that goes toward the insurance company’s costs? Are those costs worth it to you, in your situation, to obtain the benefits of a 7702? That’s a question only you can answer – ideally with the help of a fiduciary financial advisor who isn’t trying to sell you anything except advice and who is legally required to put your best interests above their own. And if you’re wealthy, you also want that advisor to be one who specializes in helping high net worth clients.
The Bottom Line
A 702(j) plan is just a marketing term for a permanent life insurance policy governed by section 7702 of the U.S. Code. These types of insurance policies are not scams, but they are only appropriate for a small subset of people who are wealthy and have exhausted most other uses for their excess cash. Even then, these policies have various complexities and pitfalls that prospective policyholders must be sophisticated enough to understand.
For most people, getting out of debt and fully funding IRAs and retirement accounts offered by employers are the best ways to “bank on yourself.” An HSA is another good option for those willing to risk a high-deductible health insurance policy. Furthermore, it does not make sense for most people to pay commissions and fees to an insurance company for the privilege of being able to borrow back their own money, with interest, even if that money does grow tax free.