Irs Code 7702
March 31, 2023

IRS Code 7702: What does It Mean on IRS Transcript?

Personal Taxes

Life is hard, and most of us cannot afford not to plan ahead. Fortunately, Section 7702 of the Internal Revenue Code (IRC) lays out the groundwork that helps taxpayers plan their future.

This section defines circumstances under which cash-value life insurance policies can retain their tax-advantaged status. The IRS Code 7702 shouldn’t be confused with the transaction, or reference codes the IRS uses on tax account transcripts.

It’s also important to note that the popular term 7702 policy doesn’t refer to any life insurance policy, such as universal life or term life.

We’ll walk you through the ins and outs of the IRS Code 7702 to help you decide if cash-value life insurance is a suitable solution for you and your family.

What is the IRS Code 7702?

This section of the IRC was first enacted in 1984. Its purpose is to lay out the requirements a contract must meet to qualify as a life insurance contract or as a modified endowment contract.

Hence, the code prevents wealthy individuals from avoiding taxation by exploiting the tax advantages of life insurance policies.

The code also stipulates when charges for qualified-additional benefits are calculated using the mortality or expense charge rules.

According to this document, a life insurance contract can qualify for federal income tax purposes if it meets the conditions below:

  • A contract must pass the cash value accumulation test
  • A contract must meet the premium requirements guidelines and fall within the cash value corridor defined in § 7702(d).

The original version of Section 7702 indicated that a policyholder must provide a minimum guaranteed interest rate of 4% to 6%.

Hence, the net of reasonable expenses and premiums paid at the end of the policy carrier’s life expectancy had to amount to at least a 4% death benefit return. High-interest rates are the primary reason most taxpayers opt for Roth and 401(k) retirement plans.

Recent Updates of the IRS Code 7702

Recent Updates of the IRS Code 7702

Consolidated Appropriations Act of 2021 has brought changes to Section 7702 that essentially went unnoticed.

The act has lowered interest rates from 4% to 2% enabling life insurance carriers to charge higher premiums for the same death benefit.

In other words, wealthy taxpayers can now allocate higher amounts of cash into their tax-advantaged life insurance policies without the risk of increasing the cost of insurance or the death benefit.

These changes also challenge whole-life policyholders because they reduce their cash value growth rates from 4% to 3% or 2%. In addition, new interest rates will affect Reduced Paid-Up non-forfeiture options that enable policyholders to stop paying premiums.

Nonetheless, recent updates of the IRS Code 7702 create a perhaps unintentional benefit for high earners by allowing tax-efficient wealth accumulation.

The Mechanics of 7702 Plans

Section 7702 of the IRC presents a contract’s requirements to qualify as a cash-value life insurance policy. 

The policy’s death benefit and cash value are regarded as the beneficiary’s taxable income if the policy doesn’t meet these requirements.

Consequently, understanding this document is instrumental when deciding whether to invest in a cash value life insurance. Section 7702A describes a modified endowment contract as follows:

‘Any contract that meets the requirements of § 7702, but fails to meet the 7-pay day test outlined in the § 7702(b).’

Remember that life insurance policies are treated differently than modified endowment contracts from the tax perspective, so you shouldn’t exceed the federal tax law funding limits.

These limits prevent the abuse of tax advantages provided by permanent life insurance policies and prevent policy carriers from putting too much cash into their policies.

GPT and CVAT

The IRS devised Cash Value Accumulation and Guideline Premium and Corridor tests insurance companies must use when establishing if a contract can be exempt from taxation.

So, let’s take a look at what these tests entail.

Cash Value Accumulation Test

As indicated in Section 7702(a), a contract can pass the cash value accumulation test ‘if the sum of premiums paid under the contract does not at any time exceed the guideline premium limitation as of that time.’

Simply put, a policyholder cannot receive more money from the policy if they cancel it than the sum they paid for the policy without fees. Therefore, the term cash surrender value refers to the money a policy carrier gets after canceling a life insurance policy.

Guideline Premium and Corridor Test

This test focuses on the policyholder’s premiums rather than the cash value. Hence, you cannot pay more premiums than necessary to fund the death benefit.

The IRS will classify your life insurance contract as a modified endowment contract if you attempt to overpay policy premiums.

Section 7702 also indicates that insurance companies can switch between these tests once they determine a contract’s tax exemption eligibility.

These tests affect premium amounts policyholders have to pay, cash value accumulation limits, and other policy benefits and features, which is why you must know which test an insurance company is using to determine if a contract can avoid taxation.

The Differences between Retirement Plans and 7702 Plans

Even though they’re often advertised as retirement plans, 7702 plans differ from standard 401(k) and traditional IRA plans.

The term 7702 plan refers to life insurance policies, commonly universal life insurance policies and variable life insurance policies, which accumulate cash value over time.

If a contract passes CVAT or GPCT, the policy’s cash value can increase within the limits outlined in Section 7702.

The IRS doesn’t offer tax deductions for 7702 plans. However, tax deductions are available for 401(k) and traditional IRA retirement plans.

You can make tax-free withdrawals of the policy’s cash value as long as the amount you withdraw doesn’t exceed the amount you invested in the policy. Furthermore, you can use 7702 life insurance policies to obtain loans without facing the tax penalty.

The only downside of borrowing against a policy’s cash value or making cash withdrawals is that you’ll decrease your death benefit. However, unlike traditional IRA or 401(k), passing a cash value life insurance to a spouse, relatives, or other beneficiaries is tax-free.

Consequently, 7702 plans aren’t like conventional retirement plans, even though they’re often marketed as similar to 401(k) and other retirement plans.

So, if you’re thinking about buying a cash-value life insurance policy, you must first take the time to find a reliable life insurance company and then closely examine the options a policy offers.

You can use online life insurance quote calculators to determine if a policy you’re considering offers favorable options.

Moreover, checking which test a company uses to determine a contract’s tax exemption eligibility is advisable because it might affect the premium you’ll pay for the policy.

Frequently Asked Questions

Can Changes of Section 7702 Affect an Active Life Insurance Policy?

The changes introduced by the Consolidated Appropriations Act of 2021 don’t apply retroactively, so the interest rates on life insurance policies issued before 2021 are unchanged. The same applies to all future changes of the IRC’s Section 7702.

Should I Buy a 7702 Plan?

You must be aware that the 7702 plan is an umbrella term for different life insurance policies before you decide to invest in such a policy. Also, you should understand that 7702 plans aren’t a replacement for retirement plans.

Is CVAT Better than GPT?

A comparison of these tests doesn’t reveal significant advantages for policyholders. For example, CVAT limits the policy’s maximum cash value, while GPT limits its premium amount.

What Happens if I Overfund a Life Insurance Policy?

CVA and GP tests prevent policy carriers from overfunding life insurance policies. Failing either of these tests results in the automatic qualification of a policy as a modified endowment contract that isn’t exempt from taxes.

Get in Contact With a CPA

Making a profitable life insurance investment can be difficult if you’re unfamiliar with Section 7702 of the Internal Revenue Code.

Although the recent changes have allowed for more accessible cash value accumulation, life insurance policies are still not an ideal replacement for retirement plans.

Go to choicetaxrelief.com or call 866-8000-TAX if you need a CPA who can help you understand the implications of IRC’s Section 7702.

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Author:

Logan Allec, CPA

Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.

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