The 7702 Plan Defined By Certified Financial Planner Neil Jesani

Background

The 7702 plan was established in accordance to Section 7702 of the U.S. Internal Revenue Code. The IRS Sec 7702 deals with the accumulation of life insurance policy cash value or account value. Prior to the writing of Section 7702, federal tax law took a fairly hands-off approach when it came to the taxation of life insurance policies. One could place an unlimited amount of money into a life insurance contract that offers tax-free death benefit, tax-deferred growth of policy account value (interest and gains that built up within the policy were not included as part of the policyholder’s current income) and tax-free distribution of this cash value via loan. This problem of stocking their investment money to the generous tax breaks given to insurance policies led people to try to pass investments off as life insurance.

Section 7702 was created in order to limit the tax benefits given to life insurance policies. It did this by defining what would be considered a life insurance policy. Investment vehicles that didn’t fall under the insurance definition were not eligible for the favorable tax treatments. In short, it kept most of tax benefits but limited how much money you can stock into the life insurance policy. This does not, however, eliminate the use of whole life and universal life insurance as an alternative means to accumulate wealth and plan for retirement while reaping the favorable tax benefits life insurance enjoys. In truth, the industry has always frowned upon the practice of buying a life insurance policy purely for the purpose of tax sheltering.

Tax Treatment of any Investments

There are three tax benefits that exist: 1) tax-deductible contributions, 2) tax-deferred growth and 3) tax-free withdrawal of growth.

Most investments such as CDs, brokerage accounts and savings accounts, only enjoy one of these three tax benefits, and that is tax-free withdrawal of growth.
Traditional qualified plans such as IRA, 401K, 403b, SEP, Simple Plan, Profit Sharing and Defined Benefit Plans enjoy tax-deductible contributions and tax-deferred growth but the 100% withdrawal will be taxed at the marginal income tax rate after the age of 59.5 of the investors. If taken before the age of 59.5, there will additional 10% excise penalty on the entire withdrawal.

Roth plans such as Roth IRA, Roth 401k and Roth like such as cash value of life insurance policy (as governed by the IRS Sec 7702) enjoy the tax-deferred growth of the account value and tax-free withdrawal of the entire account. In the case of Roth plans, the withdrawal should be after the investors’ age 59.5 or 5 years after starting of the plan, whichever is later. For cash value of life insurance policy, no such restrictions exist, and can be taken out any time.

There are two specific investment vehicles real estate and municipal bonds tax little bit differently. Real estate primarily allows the tax-deferred growth and portion of growth up to a certain dollar limit tax-free if it is the primary residence. Municipal bonds partially act like Roth plans and cash value of life insurance policy. Earnings on municipal bonds are income tax free (only federal income tax unless the investor lives in the same state and/or city of the municipal bond) but the growth in the principal (if any) will be subject to capital gains if it is held more than a year and ordinary income tax if held less than a year.

Traditional IRA/401K Vs Roth IRA/401k

With traditional IRA, 401K and other defined contributions and defined benefits plans, you get a tax deduction up front. The taxes you pay on that income are delayed until you withdraw it during retirement.

Roth IRA, 401k and cash value of life insurance policy, on the other hand, are funded with post-tax money but the growth and withdrawal are tax free.
So, the question is, which one is better? The answer is not simple and it depends on many factors such as your current income tax bracket and burden, net worth, other investment holdings, time to retire and your ability to bite the bullet now or later.

“With a traditional IRA, you’re at the mercy or uncertainty of what future higher tax rates might do to your retirement savings,” according to IRA expert Ed Slott, founder of Ed Slott & Co. “With a Roth and Roth like, you don’t have to worry about future rates, because your tax rate in retirement will be zero.”


Most expert financial planners/advisors agree that over the long term, Roth IRA is better than Traditional IRA due the fact, it is better to be taxed on the “seed” money than the “harvest” money. Also, the current national debt of 22 Trillion without unfunded liabilities such as Social Security, Medicare and Budget Deficit could be a danger to the future lower tax rate. Historically, we are living in the lowest tax-rate environment. The average top marginal tax-rate since 1913 has been 58%. Current national debt is $22 Trillion. However, if you factor in the unfunded liabilities (following GAAP accounting standards, as most public companies do), then this number is above $100 Trillion – almost $1 Million debt per tax-payer. Some day we will have to deal with it and there are only two logical ways to do so: 1) Reduce spending and/or 2) Increase revenue.

Perhaps there is a sort of comprise. You can buy cash value life insurance policy inside your traditional 401K defined contribution plan, such as a profit-sharing plan and a defined benefit plan. But keep in mind, as far as tax benefits are concerns, the traditional plan rules still supersede the life insurance tax benefits in terms of cash value withdrawal, but death benefit is still income tax free.

Rate of Return of Various Investments

There are two kinds of investments we do for wealth building: 1) Short-term and 2) Long-term.

The short-term wealth building investments are liquid assets, things like checking accounts, savings accounts, money markets and so forth for your emergencies, opportunities, security, and just overall peace of mind.

Before we look at the return of long-term savings and investments, let’s understand the underlying premise for all long-term investments, why are we giving up current enjoyment of our income? The answer is to have a comfortable income stream in retirement and pass the left-over assets to family and charity in the most efficient way. It only makes sense then to understand how retirement income streams work so that we can direct the savings we are doing today in ways that potentially gives us the highest income when we retire.

In other words, how retirement income streams work economically define how we should allocate our savings today. The sooner we get on an efficient path, the greater impact we will have on the results. There are two rates that make up everyone’s retirement income stream later on, and both are equally important. One is the accumulation rate – getting up the mountain. The other is the distribution rate – getting back down safely. Knowing how retirement income streams work and then how distribution rates work, is the basis for understanding how to save money in pre-retirement.

  • Accumulation Rate:

There are three factors that affect your investment accumulation rate – 1) Asset allocation, 2) Taxation and 3) Investment expenses.

There are three main asset classes for asset allocation: Stocks, Bonds and Cash; and three other asset classes are getting popular in last few decades: Real Estate, Commodities and Life Insurance.

According to MeasuringWorth.com (a nonprofit organization and managed by professors of top universities in the United States and Great Britain such as Harvard, Stanford, New York, Vanderbilt, Oxford and Northwestern), the annual growth rate of “Dow Jones Industrial Average” (DJIA) since its inception on 02/16/1885 to 01/18/2019 is 5.11% and of “S&P 500” since its inception on 03/04/1957 to 01/18/2019 is 6.86% and of “NASDAQ” since its inception on 02/05/1971 to 01/18/2019 is 9.32%.

The following chart shows a comparison of the six main asset classes by the average long-term return, risk category, liquidity, and tax efficient yield. The average expense ratio for actively managed mutual funds is between 0.5% and 1.0% and typically goes no higher than 2.5%. For passive index funds, the typical ratio is approximately 0.2%. Expenses can vary significantly between different types of funds. The category of investments, the strategy for investing, and the size of the fund can all affect the expense ratio. With an average expense ratio of 1.25%, large-cap funds are typically less expensive than small-cap funds, which average 1.40%. Life insurance involves two kind of policies here – Whole life and Indexed universal life. Both provide fixed interest and no expenses for managing investment, and of course you pay mortality and other administrative expenses.

Asset Class Long Term Return Risk Liquidity Taxable or Tax-free
Stocks 7% Very High Very Low Taxable
Bonds 4% Low Medium Taxable
Real Estate 6% High Very Low Taxable
Cash 2% No Risk Very High Taxable
Commodities 6% Very High Very Low Taxable
Whole Life Insurance 4.5% No Risk Medium Tax-free
S&P Indexed Universal Life 6.86% Low Medium Tax-free
  • Distribution Rate:

Fidelity suggests limiting retirement income withdrawal or a distribution of 4% to 5 % of your savings/investments. That recommendation is largely in line with the 4% rule, a withdrawal regimen that traces its origins to a 1994 study by now-retired financial planner William Bengen. Essentially, Bengen tested a variety of withdrawal rates using historical rates of returns for stocks and bonds. He found that 4% was the highest withdrawal rate (even though you can earn higher accumulation rate) retirees could use if they wanted their money to last at least 30 years, assuming they invested in the most optimal portfolio of 60% bonds and 40% stocks.

In recent years however, a number of experts have challenged this rule, warning that it no longer offers the same level of assurance against running through one’s assets that it did in the past. “The problem is that at today’s low interest rates bonds can’t provide the same level of income they previously did,” says Wade Pfau, professor of retirement income at the American College of Financial Services. “That means investors have to rely more on the equity portion of their portfolio to support withdrawals.” Since stock returns are highly volatile, if you withdraw more than you earn in a particular year, you have killed a portion of your working principal that is then no longer available when stock market goes up.

The Economic Power of Combining Two Rates

The first economic power we all have to work with is the Rates of Return power which can be a good accumulator of money. The second economic power is Actuarial Science which can be a good distribution power. These powers were always meant to work together in proper balance.

If we don’t incorporate distribution power, then we can be defaulting ourselves to the 3-4% income rate problem. When we incorporate Actuarial Science along the way we put ourselves on a path that can potentially provide higher retirement income rates from the assets we’ve built. The balancing between these economic powers is the key. Having too much of either can make you less efficient. Then the power of actuarial science, through the death benefits and cash values of the whole life insurance or indexed universal life, can interact with the interest rate power of retirement assets to create the ability to take higher retirement income rates safely. One needs to be working towards building the proper balance between these two powers on their way to retirement.

The interaction of these two cornerstones provides both the exchange/trade option which we call the Covered Assets, and the investment option which we call the Volatility Buffer to choose from at the time of retirement. A covered retirement asset is one that is accompanied by an equal amount of whole life insurance death benefit. Similar to how most government entities provide retirement pensions to their employees, covered retirement assets lay the foundation for self-made pensions in retirement. This is accomplished through the interaction of a retirement income tool that is unrelated to the curves of the withdrawal rate simulations called an income annuity, a self-made pension, and your whole life insurance death benefit.

Under this option the interaction of your other retirement assets and cash value life insurance gives you the ability to create a guaranteed retirement paycheck for life historically in the range of 7% to 13% from the assets you’ve built, while at the same time providing perpetuation of retirement income for a spouse and/or a legacy for your heirs.

We have helped thousands of successful individuals to almost double their retirement income or distribution rate and created various retirement income options. If this something you want for yourself then please call (877) 972-3262 or complete contact us form now.