What is a 702(j) retirement plan, and should you get one?

By Dave Anthony, CFP®, RMA®

In recent months, so-called 702(j) plans have been marketed by insurance salesmen as a new kind of retirement plan, and they have sparked plenty of consumer questions about whether it’s an investment vehicle they should pursue. Here is a closer look at what these plans are, and are not.

First, a 702(j) plan is not a retirement plan at all — it is a life insurance contract. It is defined under Section 7702 of the United States Code (hence the name), which states that for a financial product to qualify as a life insurance contract, it must pass one of two tests:

1. Cash Value Accumulation Test (CVAT) –makes sure that the cash value of the insurance policy (all of the money that you’ve paid plus earnings) does not exceed the present value of all future payments on the policy.

2. Guideline Premium Test (GPT) – limits the amount of money that can be paid into an insurance policy relative to the corresponding death benefit.

If it does, then the financial product can be taxed as life insurance! Hooray! This really is a big deal because a properly designed and funded cash value life insurance policy (universal life, whole life, variable universal life) is one of the last great tax shelters available, which means that the monthly premiums that you pay can (1) grow tax-deferred, (2) can be accessed tax-free via policy loans, and (3) the death benefit can be received income tax-free. A properly designed cash value life insurance plan can also be viewed as a 4^th asset class, or another “leg” of your retirement income stool When you retire, you want to have a strong, sturdy retirement stool to stand on, one that is well balanced and diversified. So in addition to retirement income that you may derive from Social Security (1), Pension (2), and Investments (3), now you have the option of taking income from a cash value life insurance policy (4).If you want to get crazy you can read the code at: https://www.law.cornell.edu/uscode/text/26/7702.

Why would you want to have different asset classes available at retirement to pull income from? Because our country is $19 trillion in debt and there is roughly $19 trillion in IRA/401(k) & profit sharing plans. How is Washington going to pay for this debt? You got it, they’re going to take it from your accounts in the forms of higher health care costs in retirement via the increase of Part B and Part D Medicare premiums, tax more of your Social Security payments, and not index either of these for inflation. Over time, more and more of the 10,000/day baby boomers who are retiring will become subject to the extra penalties and taxes. Brilliant! That is of course, unless you are a prepared baby boomer retiree and have strategically allocated your retirement income monies to come from accounts that don’t count towards the Social Security provisional income or Medicare Modified Adjusted Gross Income (MAGI) calculations, but that is a topic for another nerd wallet post.

Once you know how much money you can deposit into your 702(j) plan each year under the CVAT and GPT tests, then you’ll want to try to put as much as possible into these plans, as soon as you can. Generally it is a good idea to make contributions for at least 8-10 years before you take any money out, because this will give your policy more time to grow and for earnings to compound. This is what is meant by a properly designed and funded life insurance plan.

These plans can be equally effective for a young 30 something just getting started, as they are for a 60 year old Baby Boomer looking towards retirement in the near future.

The idea of using a life insurance contract or a “702(j) retirement plan” to supplement your retirement income is not new. People have been using permanent life insurance for decades, and the popular sales pitch is that “wealthy people have been doing this for years,” implying that the rest of us should as well.

The plan is that you put more than the minimum required premium payment under the GPT and CVAT tests into a cash value life insurance policy (universal life, whole life, variable universal life) during your savings years. Later on, you can then withdraw money out of the policy via a tax-free policy loan to pay for your retirement, buy a car, put kid through college, or whatever purpose you want the money for.

I recently ran an illustration for a 60 year old male who wanted to diversify his retirement income and do some pre-planning to reduce the taxes on his Social Security income and avoid the Medicare Part B & D premium surcharges that he would be exposed to once he started taking the Required Minimum Distributions (RMD) out of his IRA plan at 70 ½. The impact of these two things is not insignificant. His SS income was expected to be about $32,000/year, and his IRA distributions would make up to 85%, or $27,200, taxable as ordinary income. Worse, since he was up against the $85,000 income threshold for Medicare Part B and D premiums, just $1 additional dollar of income would bump him into the Medicare “level I” Income Related Premium category, which would cost him an additional $1,600/year. That, combined with $6,800 more in Social Security income taxes, means that he would be paying $8,384/year more in taxes and Medicare surcharges than someone who had proper planning. Over a 25 year retirement life, that amount invested at 8% each year grows to more than $670,000!

The illustration showed him depositing $78,079/year into the plan for 4 years for a total of $300,000. Starting at age 67, he could then withdraw $32,469/year out of the plan for the rest of his life, all tax-free, and not included in the Social Security or Medicare premium penalty calculations. This provided him with a $1 million death benefit, that gradually decreased as he started withdrawing monies out of the plan.

For a younger client, a 30 year old male putting in $10,000/year into a properly structured plan could have an initial death benefit of around $400,000, and could withdraw $100,000 at age 45 to pay off debt, reinvest, start a business, whatever. At age 65 he could then withdraw $112,000/year for life, tax free. 

The life insurance sales industry has long had catchy monikers to describe this kind of product, like “Bank on Yourself,” “Be Your Own Bank,” “Infinite Banking” and others. A 702(j) loan is tax free, provides a tax-free death benefit and is some states is 100% protected from creditors.

Should you get one? Well, that depends. First off, you need to recognize that life insurance has fees associated with it.

You have to pay for the cost of the insurance, mortality and expense charges, administration charges, annual policy fees, state taxes, and the marketing expenses (commissions) that go to whomever is telling you about the plan. Second, you really need to thoroughly understand the illustration, or the “projections”, that you are being shown. Make sure that you can properly fund the policy. Setting up one of these plans is like purchasing an expensive car–lots of benefits, but your maintenance costs, insurance, gas, etc. adds up and you need to take care of your purchase. The web is full of dissatisfied 702(j) purchasers who rue the day they started the plan, just like people who bought expensive cars that were out of their price range and they couldn’t keep up with the maintenance. Don’t blame the car manufacturer for your inability to properly service things!.

The allure of the policy is that a properly constructed, managed, and funded life insurance contract can provide the disciplined retiree with another source of retirement income that is completely tax-free. This means no social security taxes, income taxes, Medicare taxes, or investment surcharge taxes. There’s no pre-59 ½ withdrawal penalty, required minimum distribution income thresholds to set one up.

So, does it make sense to trade the fees of the insurance policy for the taxes to the IRS?

The answer to this question can only be answered by doing a complete analysis of your financial situation and calculating what your tax burden is. Generally, it makes mathematical sense for someone to maximum-fund their 401(k), IRAs, and Roth IRA accounts before they go out and purchase any 702(j) plan or look at using life insurance as a retirement income supplement.

Are you doing all of these things and still have disposable income that you want to save for the future? If so, a properly constructed 702(j) plan may make sense. For high wage earners who are expected to have high incomes in retirement, the answer is simple — absolutely. As stated, loans from life insurance contracts don’t count as income in retirement. They don’t count towards the Provisional Income test to determine how much of your Social Security is taxable in retirement (up to 85% can be taxable), they don’t count towards the Medicare Part B premium penalty surcharges, and most importantly, they don’t have required minimum distributions (RMDs) like qualified plans such as IRA and 401(k) plans that require you to take distributions out of your plans at age 70 ½ whether you need it or not. RMDs are taxed as ordinary income, and for many retirees this causes a domino effect and bumps them up into unnecessary Social Security taxation and Medicare Part B premium penalties.

This can all be avoided by having tax diversification in retirement, and a properly funded life insurance contract can do exactly that. 

If I am discussing the suitability of this type of product with a client, I look for ways that we can properly manage their existing deductions and tax brackets first, and put as much money as possible into their qualified plans. Once retirement time comes, then we strategically convert these taxable retirement accounts over to tax-free Roth accounts and reduce their income taxes payable via smart tax bracket planning, strategic Social Security claiming strategies, and the proper use of charitable remainder trusts and tax-deduction techniques that dramatically reduce their income taxes payable in the year of conversion.

This way, the investor really can have their cake and eat it, too — they get a tax deduction on their initial IRA/401(k) contribution, and they pay a lower effective tax rate when they convert the monies over to a Roth account via the strategies described above, and enjoy all of the tax-free benefits of the Roth. Halleluiah!

If we do decide to go with a 702(j) plan, then I will generally recommend a commission-free, low-cost variable universal life policy (VUL) as the funding vehicle instead of the more expensive whole life and indexed universal life alternatives. Most insurance salesmen don’t even mention the commission-free VUL route because they are simply unfamiliar with this option and don’t understand how it works. Plus there is no commission to be made on the sale, so there is no incentive to bring it up. That being said, it pays to work with a professional who knows how they both work. Seek out someone who can compare and contrast the different policies and get at least three illustrations from the best VUL, IUL, and permanent whole life companies before you commit to anything. It is a lot of work for the insurance agent, but this is your money, and your life and you want to make the right choice.

Over time, the ability to receive a tax deduction on your IRA/401(k) contribution, convert to a Roth account at a lower rate via tax deduction vehicles, and have a properly funded VUL/IUL(indexed universal life) or whole life plan in retirement will give future retirees the ultimate in tax savings and diversification that will be worth hundreds of thousands of dollars throughout the remaining life span of the retiree, which could be 30 years or more.