By Dave Anthony, CFP
In recent years, insurance salesmen have been marketing the 702(j) account (a.k.a. 702 or 7702 account) as a new kind of retirement plan. There are several things consumers should know before deciding whether these plans are an investment vehicle worth pursuing:
A 702(j) is not actually a retirement savings plan at all. It’s an insurance policy — specifically a permanent life insurance policy — as defined under Section 7702 of the United States Code. Calling it by its tax code name instead of what it really is (reminder: insurance) cleverly makes consumers think a 702(j) is in the same category as retirement investing products like 401(k)s, 403(b)s and IRAs. It’s not.
Using a life insurance to supplement retirement income isn’t a new invention. People have been using permanent life insurance for decades. The popular sales pitch that it’s a special loophole that only wealthy people have known about falsely implies that it’s something the rest of us should be using as well.
Generally, a 702(j) doesn’t make mathematical sense for most people. Despite the aggressively marketed high points — including that monthly premiums you pay can grow tax-deferred and be accessed tax-free via policy loans — the 702(j) is not the holy grail of retirement accounts. The problem? High fees, middling investment returns (because of those high fees) and the fact that the traditional retirement investment options you’ve heard about are better for the majority of savers.
What’s a better alternative?
Before even considering purchasing any 702(j) plan or any life insurance to supplement your retirement income look first to the savings vehicles that are proven winners for most people:
Fully fund your 401(k)
- For tips on making the most of the account see How to invest in your 401(k).
- Use our 401(k) calculator to see what your balance will be at retirement
Fully fund an IRA
- Roth vs. traditional IRA? A side-by-side IRA comparison to see which is best for you.
- Best account providers for IRAs and best Roth IRA accounts
In a perfect world, you’d max out both. If that’s not an option, here’s how to prioritize your retirement savings dollars according to a general 401(k) vs. IRA pecking order.
It’s only after you fully fund your 401(k) and IRAs and you still have disposable income that you want to save for the future that a properly constructed 702(j) plan may make mathematical sense. If that describes you, then let’s get into the details to see if it does make sense.
Here’s what the hype’s about
The sales pitch for a 702(j) is this: Since it’s technically life insurance, it’s taxed as life insurance rather than 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.
A 702(j) sounds great, until you get to what it costs.
The idea is that you put more than the minimum required premium payment 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.
Sounds great, until you get to what it costs.
Buying a 702(j) is like buying an expensive car
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.
Who it makes sense for
Because life insurance contracts don’t count as income in retirement, high wage earners who expect to have high incomes in retirement might find a 702(j) an especially good fit. The benefits are:
- 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 (RMDs), in contrast to IRAs and 401(k) plans that require you to take distributions at age 70½ whether you need the money or not. Because RMDs are taxed as ordinary income, it could cause a domino effect for retirees and bump 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.
It all comes down to taxes
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.