Section 7702

What Is Section 7702?

Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code characterizes what the federal government views as a genuine life insurance contract and is utilized to decide how the proceeds the policy creates are taxed.

The proceeds of policies that don't meet the government's definition are taxable as ordinary income. Proceeds from genuine life insurance contracts are tax-advantaged. Section 7702 applies just to life insurance contracts issued after the year 1984.

Understanding Section 7702

Before the adoption of Section 7702, federal tax law took a decently hands-off approach when it came to the taxation of life insurance policies. Death benefits paid to life insurance beneficiaries were exempt from income tax, and any gains that accrued inside the policy during the policyholder's lifetime were not taxed as income.

While this ideal tax treatment might look reasonable on its surface — the government would have rather not been seen taxing poor widows and kids — issues emerge when the system can be manipulated, for example, when different types of investment accounts are made look like life insurance products.

To keep this from occurring, Section 7702 made a rundown of requirements used to guarantee that main genuine life insurance policies received worthwhile tax treatment and not investment vehicles taking on the appearance of them.

Requirements of Section 7702

Life insurance contracts need to breeze through one of two assessments: the cash value accumulation test (CVAT) or the guideline premium and corridor test (GPT).

Cash Value Accumulation Test

The cash value accumulation test specifies that the cash surrender value of the contract "may not out of the blue surpass the net single premium which would need to be paid at such opportunity to fund future benefits under the contract."

That means that the amount of money a policyholder could escape the policy if they somehow managed to cancel it (frequently alluded to as the "reserve funds" part of cash value life insurance) can't be greater than the amount that the policyholder would have paid to purchase the policy with a single lump sum, excluding any fees.

Guideline Premium and Corridor Test

The guideline premium and corridor test requires that "the sum of the premiums paid under such contract doesn't whenever surpass the guideline premium limitation as of such time." This means that the policyholder can't have paid more into the policy than would be needed to fund its insurance benefits.

Assuming that a life insurance policy neglects to breeze through both of those assessments, Section 7702(g) specifies that the income on the contract will be treated as ordinary income for that year and taxed likewise. As such, the owner of the contract will lose the ideal tax treatment of a true life insurance policy.

Features

• Certain types of permanent life insurance build up a cash value over the long run.
• An insurance policy that bombs Section 7702 criteria turns into a modified endowment contract (MEC) and permanently loses its tax-advantaged status.
• Section 7702 of the Tax Code separates between income from a genuine insurance product and income from an investment vehicle.
• The proceeds of a true life insurance contract receive ideal tax treatment.
• The proceeds of a contract that doesn't meet the IRS definition are taxed as ordinary income.

FAQ

What Is a Modified Endowment Contract (MEC)?

A modified endowment contract (MEC) is a permanent life insurance policy that bombs the Section 7702 criteria since it has been "overfunded" with too much cash value relative to the size of its death benefit, as defined by IRC Section 7702a. Rules set out by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) determine a seven-pay test, by which premiums paid into the policy can't surpass the total necessary amount to have the policy completely paid up in seven years or less. On the off chance that an insurance policy turns into a MEC, it loses its tax benefits and can't return to a non-MEC status.

When Was Section 7702 of the Tax Code Written?

Section 7702 and generally related subsections were sanctioned in 1984.

Why Are Permanent Life Insurance Contracts Given Favorable Tax Treatment?

Life insurance contracts are planned by design to give a cash benefit to one's beneficiaries when they die. While the insured is as yet alive, permanent life insurance contracts like whole or universal life can gather a cash value that can be removed or borrowed against. But, since these contracts are seen as insurance, and not as an investment, they are allowed certain tax benefits. A policy loan, for instance, is received tax-free.