How Section 7702 Can Help with Tax Diversification

Thomas Losher   |   June 2024   |   3-minute read

There are lots of moving parts in a financial plan, and one of the most important areas to consider is tax diversification. As you invest your clients’ assets, finding a mix of vehicles and maximizing any available favorable tax treatment is no doubt a top priority. And, even if it’s not your first thought, permanent life insurance can be a big help in reaching this goal. That’s where Section 7702 comes in.

Section 7702 refers to the IRS tax code and lays out the specific requirements life insurance policies must have to meet favorable tax treatment. There are two main tests the policies must meet:

  1. Cash Value Accumulation Test (CVT): Permanent policies, also referred to as cash value life insurance, contain a separate account, called cash value, that can be available for policy owners to access. If the policy owner decides to surrender the policy, the Cash Value Accumulation Test requires any cash value received can’t equal more than the premiums paid.
  2. Guideline Premium and Corridor Test (GPT): If cash value is too high, the IRS can tax the policy as an investment rather than life insurance. GPT is used to determine if the policy exceeds federal tax-law limits.

Policies that qualify under Section 7702 build cash value that can be later used for a tax-free loan if needed.

And a Section 7702-based strategy is just that—a strategy designed to take advantage of the tax breaks that only life insurance can provide.

Advantages of Section 7702-Based Planning

In addition to the tax advantages, life insurance offers some inherent benefits not seen in other products. Top of the list are flexibility and liquidity.

Depending on the client’s goals, they have the option to skip or catch up on premiums, giving them control of how the cash value grows inside the policy. Likewise, they can choose to take out cash value as needed, with the ability to elect multiple tax-free loans. And, unlike with qualified funds, there are no penalties for withdrawing cash from the policy prior to age 59 ½. Policy expenses are also lower than you might expect, and often lower than with other many other vehicles.

And, of course, there’s always the tax-free death benefit, ensuring that heirs don’t lose their inheritance to a bunch of taxes.

Examples of Section 7702-Based Strategies

The death benefit is usually the first element considered, but it can be secondary to accumulating cash value when using a 7702-based strategy. In addition to being used for unseen events, cash value can also be earmarked for specific expenses, such as:

  • Income in retirement (sometimes referred to as life insurance retirement planning, or LIRP)
  • Down payment on a home
  • College tuition
  • Long-term care costs

Incorporating Section 7702-Based Planning into Your Practice

Getting started is as easy as spotting situations (such as those highlighted above) suited for 7702-based strategies and discussing the idea of using life insurance for tax-efficient planning with your clients.

Keep in mind that life insurance requires underwriting, so it’s important to talk with clients about any health concerns. Ideally, these strategies work best with high-income clients age 60 or under who are interested in tax diversification and long-term savings. These clients will also be concerned about future tax hikes, believing there’s a strong possibility of taxes increasing in the future.

If you’re ready to dive in, your Ash team is ready to help. And if you’re looking for more information, we’ve got you covered there too. Check out our Tax-Efficient Income Planning Playbook to get the details on the benefits of which we’ve just started scratching the surface. But either way, make tax-free income part of your discussions with your clients.

About the Author

Thomas Losher , CFP® helps simplify the technical aspects of cash value life insurance and change the broad misperceptions that exist around life insurance. As an Advanced Markets Analyst, he bridges the gap between highly complicated concepts and the unique uses of life insurance solutions.