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.”