Email FacebookTwitterMenu burgerClose thin

IRS Section 7702: Life Insurance Tax Definition


Life insurance can be a valuable addition to your estate plan if you’re interested in leaving a death benefit behind for your loved ones. Some life insurance policies also offer the opportunity to accumulate cash value through an investment component. When purchasing life insurance, you may be wondering whether cash value or death benefits are taxable. Section 7702 of the Internal Revenue Code (IRC) determines when life insurance proceeds can and cannot be taxed. Before purchasing a policy, it’s important to understand how the 7702 rules work.

Life insurance isn’t the only way to benefit your loved ones after you die. A financial advisor can help you sort through your alternatives for leaving a legacy.

What Is IRS Section 7702?

Section 7702 of the IRC defines life insurance contracts for taxation purposes. Specifically, this part of the code is used to distinguish genuine insurance contracts from investment products that are marketed as being similar to insurance.

Ordinarily, life insurance contracts offer tax-free death benefits to beneficiaries. Cash value policies can also offer tax-free growth. Section 7702 is designed to prevent abuses of the tax-advantaged nature of life insurance. It does so by imposing a two-pronged test on life insurance contracts.

How the Section 7702 Test Works

The IRC outlines two tests that life insurance contracts must pass in order to retain their tax-advantaged status. Policies can either use the cash value accumulation test (CVAT) or the guideline premium and corridor test (GPCT).

Cash Value Accumulation Test

The cash value accumulation test says that the cash surrender value of a life insurance contract can’t be more than the sum total of all future premium payments due. What this means in simple terms is that if you could pay a lump-sum premium to fully fund the policy, the cash value at surrender would have to be less than that amount. If the cash value is more than any future payments you’d need to make to satisfy the premiums, then the contract fails the cash value accumulation test.

In that case, the IRS says that you have an investment product, not a life insurance contract. This means any proceeds from the product would be considered taxable, either as ordinary income or capital gains. This could put you or your beneficiaries into a higher tax bracket when surrendering the policy or receiving a death benefit.

Guideline Premium and Corridor Test

The guideline premium and corridor test has a different set of requirements. Instead of looking at cash value, this test focuses on premiums paid. Specifically, the GPCT standard says that an insured person can’t pay more into the policy than is necessary to fully fund the death benefit. Again, if a life insurance contract fails this test then cash value or death benefits would lose their tax-advantaged status.

IRS Rules for Applying CVAT and GPCT

Section 7702 specifies that insurance companies must only use one or the other test for determining whether a life insurance contract can avoid taxation. Once the insurance company selects either the cash value accumulation test or the guideline premium and corridor test for a particular policy, they can’t flip-flop later and use the other test.

As an insurance purchaser, it’s also important to understand how the choice of test might affect you. Generally, whether an insurance company uses CVAT or GPCT guidelines can influence what you’ll pay for premiums. It can also impact cash value accumulation as well as other policy features and benefits.

7702 Plans vs. Retirement Plans

"INSURANCE" umbrella over figures of family members

If you work for an employer rather than being self-employed, it’s possible that you may be offered access to a 7702 plan as part of your benefits package. While 7702 plans may be marketed as a type of retirement plan they’re actually quite different from a standard 401(k) or similar workplace retirement savings option. A 7702 plan is essentially a life insurance policy that accumulates cash value. Depending on which company is issuing the plan this could be a variable life insurance policy or a universal life insurance policy. Cash value grows inside the policy on a tax-deferred basis, assuming the contract meets the CVAT or GPCT guidelines. That’s similar to a traditional 401(k) or traditional IRA.

But there are some key differences. First, there’s no tax deduction for 7702 plans. Contributions to a 401(k) or traditional IRA, on the other hand, can be tax-deductible. You will, however, pay income tax on qualified withdrawals in retirement.

With cash value life insurance, the cash value can be withdrawn tax-free as long as the amount doesn’t exceed what you’ve paid in. You may also be able to borrow against the policy through a loan, without incurring a tax penalty the way you might with a 401(k) loan or early IRA withdrawal. But taking out a loan or withdrawing cash value can reduce the policy’s death benefit.

You can pass on a cash value policy to your beneficiaries with a tax-free death benefit, again, assuming that the policy passes a Section 7702 test. Leaving a 401(k) or IRA to a spouse or other beneficiary, however, can trigger tax implications for the person inheriting those funds.

Bottom line, a 7702 plan isn’t the same as a retirement plan, even if it’s presented to you that way. While cash value life insurance may be a good fit for your financial strategy, it’s not an exact substitute for other types of qualified retirement plans when investing for the long-term.

Tips for Purchasing Cash Value Life Insurance

If you’re interested in buying cash value life insurance, take time to compare life insurance companies first. Consider their overall reputation first, then explore policy options. Specifically, consider coverage minimum and maximum limits, types of cash value policies available and what you might pay in premiums. It’s relatively easy to get life insurance quotes online.

Once you’ve applied for a policy, be sure to understand what you’re getting before signing off on the contract. While it’s rare to come across a cash value policy that doesn’t meet the 7702 guidelines, it’s still a possibility. So be sure to ask the insurance company which test they used to ensure that the contract they want to issue to you meets the IRS standards. If an insurance company seems unwilling to disclose that information that may be a sign that you should look elsewhere for coverage.

The Bottom Line

Mother and newbornCash-value life insurance may be a better fit for some people than term life insurance, depending on what you need for your financial situation. Section 7702 of the IRS code is designed to ensure that cash value life insurance policies aren’t misused as tax shelters. If you have a cash value policy in place already, it’s likely that your contract has passed the cash value accumulation test or the guideline premium and corridor test.

Tips for Financial Planning

  • For a quick estimate of how much life insurance you need, check out this free, easy-to-use life insurance calculator.
  • Consider talking to a financial advisor about which type of life insurance is right for you or whether your existing coverage is sufficient. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect, within minutes, with professional advisors in your local area. If you’re ready, get started now.

Photo credit: ©, ©, ©