You have probably heard of a 401(k) or a 403(b). 401(k) and 403(b) are named after their respective sections of the tax code. There is no section 702(j) section of the tax code that relates to retirement plans or tax-deferred savings.
A 702(j) plan is based on Section 7702 of the tax code, which relates to life insurance policies. It is really just a marketing tactic to re-purpose a life insurance policy as a retirement savings plan.
Here are a few quick facts about a 702(j) before we dive in:
- Can provide tax-free income in retirement if strict guidelines are followed.
- Needs to be monitored carefully.
- Geared towards high net worth individuals or investors who expect to be in a high tax bracket during retirement.
How Does a 702(j) Plan Differ from Retirement Plan?
The first obvious difference is mentioned above: A 702(j) isn’t a retirement plan at all.
It is a whole life, or cash value insurance policy. Unlike a term life insurance policy, a cash value policy covers the insured for their entire life, as long as they pay the premiums. It also adds the option of paying additional premiums that are held as cash in the policy.
Another difference from many traditional retirement plans is that a 702(j) cannot be purchased through an employer. Because it is a life insurance plan, you can only set it up with an insurance representative or financial services agent.
The benefit to this is that a 702(j) requires a relationship with an advisor who will keep a close watch on the policy to make sure no premiums are missed and that cash withdrawals are staying within certain thresholds. The drawback is that unlike retirement plans, you might pay high commissions and transaction fees.
A third, and pretty significant difference, is the timing of the potential tax benefits. With most traditional retirement plans, the money put into the plan is tax deferred. However, retirement funds are taxed when withdrawn.
With a 702(j), you pay the premiums and cash deposits with post-tax dollars. Tax burdens are not realized until later. So, a 702(j) plan is sometimes beneficial for someone expecting to be in a higher tax bracket in retirement.
In addition, most employer-sponsored retirement plans have contribution limits. With a 702(j), because it is a life insurance policy, there is not a true limit on how much an individual can contribute into the account. However, there are certain limitations regarding excess premiums in order to keep favorable tax treatment that are best discussed with a professional.
How Does a 702(j) Plan Work?
With a 702(j) plan, the purchaser pays the cash value life insurance premiums each month. The individual can then pay additional funds to the plan, called over funding. This creates a cash reserve in the account.
After an amount of time, if they meet all requirements of the plan, the purchaser might be able to withdraw cash as tax-free income. This is considered a loan, and sometimes interest will need to be paid. The loan, in most cases, does not have to be paid in the beneficiary’s lifetime.
Why Would You Use a 702(j) Plan for Retirement?
So, why would someone use a life insurance plan for retirement? Most people probably wouldn’t. But, in some cases it might be beneficial.
- If someone has a high net worth and is expecting to be in a high tax bracket in retirement, it might have its benefits.
- If the contribution limits on other retirement products have been met, a 702(j) plan could be beneficial for accessing cash in retirement.
You will notice the list of drawbacks is much longer than the benefits, but that does not mean a 702(j) plan might be the appropriate choice for some individuals. The key is working with a trusted financial advisor or insurance agent who will set up the plan and closely monitor it so that all rules are followed.