By Dave Anthony, CFP
Learn more about Dave on NerdWallet’s Ask an Advisor
In recent months, insurance salesmen have been marketing 702(j) plans as a new kind of retirement plan. This has sparked plenty of consumer questions about whether these plans are an investment vehicle worth pursuing. Here’s a closer look at what these plans are — and are not.
First, a 702(j) plan is not a retirement plan at all — it’s a life insurance contract. It’s defined under Section 7702 of the United States Code (hence the name), which states that for a financial product to qualify as a life insurance contract, it must pass one of two tests:
- The cash value accumulation test makes sure that the cash value of the insurance policy — all of the money that you’ve paid, plus earnings — does not exceed the present value of all future payments on the policy. (“Present value” is what an amount of money in the future is worth in today’s dollars, factoring in the expected rate of return.)
- The guideline premium test limits the amount of money that can be paid into an insurance policy relative to the corresponding death benefit.
If it passes one of these tests, the financial product can be taxed as life insurance rather than as an investment. That means the monthly premiums you pay can grow tax-deferred and be accessed tax-free via policy loans. It also means the beneficiary can receive the death benefit free of income taxes.
The idea is that you put more than the minimum required premium payment under the two tests into a cash-value life insurance policy — universal life, whole life or variable universal life — during your savings years. Later on, you can withdraw money from the policy via a tax-free loan to pay for your retirement, buy a car, put kids through college or whatever you want. This can be another income option in retirement, to go along with Social Security, pensions and investments.
If you go this route, it’s generally a good idea to make contributions for at least eight to 10 years before you take any money out, because this will provide more time for your policy to grow and your earnings to compound.
The idea of using a life insurance contract or a “702(j) retirement plan” to supplement retirement income isn’t new. People have been using permanent life insurance for decades, and the popular sales pitch is that wealthy people have been doing this for a long time — implying that the rest of us should as well.
The life insurance sales industry has long had catchy slogans for this kind of product, like “Bank on Yourself,” “Be Your Own Bank,” “Infinite Banking” and others.
Like buying an expensive car
Should you get one? Well, that depends. First, you need to recognize that life insurance has fees associated with it. You have to pay for the cost of the insurance, mortality and expense charges, administration charges, annual policy fees, state taxes and the marketing expenses (commissions) that go to whomever is telling you about the plan.
Second, make sure you can fund the policy properly. Setting up one of these plans is like purchasing an expensive car — you get lots of benefits, but your maintenance costs, insurance, gas, etc., add up, and you need to take care of your purchase. The Internet is full of dissatisfied 702(j) purchasers who rue the day they started the plan, just like people who bought expensive cars and found they couldn’t keep up with the maintenance.
So does it make sense to trade the fees on the insurance policy for the taxes to the IRS?
The only way to find out is by doing a complete analysis of your financial situation and calculating what your tax burden is. Generally, it makes mathematical sense for people to fully fund their 401(k), IRA and Roth IRA accounts before they purchase any 702(j) plan or look at using life insurance to supplement their retirement income.
If you’re doing all of these things and you still have disposable income that you want to save for the future, a properly constructed 702(j) plan may make sense. High wage earners who expect to have high incomes in retirement might find it an especially good fit. That’s because life insurance contracts don’t count as income in retirement.
They don’t count toward the provisional income test to determine how much of your Social Security is taxable in retirement (up to 85% can be taxable). They don’t count toward the Medicare Part B premium penalty surcharges.
Most importantly, they don’t have required minimum distributions, in contrast to IRAs and 401(k) plans that require you to take distributions at age 70½ whether you need the money or not. Required minimum distributions are taxed as ordinary income, and for many retirees this causes a domino effect and bumps them up into unnecessary Social Security taxation and Medicare Part B premium penalties.
This can all be avoided by having tax diversification in retirement, and a properly funded life insurance contract can provide that.
Tax implications are key
If I’m talking with clients about whether this type of product is suitable, I look for ways that we can properly manage their existing deductions and tax brackets first, and put as much money as possible into their qualified plans. When it’s time for them to retire, we strategically convert these taxable retirement accounts to tax-free Roth accounts and reduce their income tax obligations via smart tax-bracket planning, strategies for claiming Social Security benefits, and the proper use of charitable remainder trusts and tax-deduction techniques.
If we decide to go with a 702(j) plan, I generally recommend a commission-free, low-cost, variable universal life policy as the funding vehicle, instead of the more expensive whole life and indexed universal life alternatives. It pays to consult with a professional who knows how all of them work. Seek out someone who can compare and contrast the different policies before you commit to anything. This is your money and your life, and you want to make the right choice.
Over time, the ability to receive a tax deduction on your IRA and 401(k) contributions, convert to a Roth account at a lower rate via tax-deduction vehicles and have a properly funded insurance plan in retirement can give you the ultimate in tax savings and diversification.