What Is Section 7702?
Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code defines what the federal government considers to be a legitimate life insurance contract and is used to determine how the proceeds the policy generates are taxed.
The proceeds of policies that do not meet the government's definition are taxable as ordinary income. Proceeds from genuine life insurance contracts are tax-advantaged. Section 7702 applies only to life insurance contracts issued after the year 1984.
- Section 7702 of the Tax Code differentiates between income from a genuine insurance product and income from an investment vehicle.
- Certain types of permanent life insurance build up a cash value over time.
- The proceeds of a true life insurance contract receive favorable tax treatment.
- The proceeds of a contract that does not meet the IRS definition are taxed as ordinary income.
- An insurance policy that fails Section 7702 criteria becomes a modified endowment contract and permanently loses its tax-advantaged status.
Understanding Section 7702
Prior to the adoption of Section 7702, federal tax law took a fairly hands-off approach when it came to the taxation of life insurance policies. The government did not want to be seen taxing needy widows and children, so death benefits paid to life insurance beneficiaries became exempt from income tax. Any gains that accrued within the policy during the policyholder's lifetime were not taxed as income.
While this favorable tax treatment may look reasonable on the surface, problems arise when the system can be rigged, such as when other types of investment accounts are passed off as life insurance products.
To prevent this from happening, Section 7702 created a list of requirements used to ensure that only genuine life insurance policies received advantageous tax treatment and not investment vehicles masquerading as them.
Insurance policies that fail to meet Section 7702 criteria become modified endowment contracts (MECs). As such, they permanently lose any tax-advantaged status they had.
Requirements of Section 7702
Cash Value Accumulation Test
The cash value accumulation test stipulates that the cash surrender value of the contract "may not at any time exceed the net single premium which would have to be paid at such time to fund future benefits under the contract."
That means that the amount of money a policyholder could get out of the policy if they were to cancel it (often referred to as the savings component 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, not including any fees.
Guideline Premium and Corridor Test
The guideline premium and corridor test requires that "the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitation as of such time." This means that the policyholder can't have paid more into the policy than would be necessary to fund its insurance benefits.
If a life insurance policy fails to pass either of those tests, Section 7702(g) stipulates that the income on the contract will be treated as ordinary income for that year and taxed accordingly. In other words, the owner of the contract will lose the favorable tax treatment of a true life insurance policy.
Why Are Permanent Life Insurance Contracts Given Favorable Tax Treatment?
Life insurance contracts are intended by design to provide a cash benefit to one's beneficiaries when they pass away. While the insured is still alive, permanent life insurance contracts like whole or universal life can accumulate a cash value that can be withdrawn or borrowed against. But, because these contracts are viewed as insurance, and not as an investment, they are granted certain tax benefits. A policy loan, for example, is received tax-free.
What Is a Modified Endowment Contract?
A modified endowment contract is a permanent life insurance policy that fails the Section 7702 criteria because 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 specify a seven-pay test, whereby premiums paid into the policy cannot exceed the total amount that would be needed to have the policy fully paid up within seven years.
If an insurance policy becomes an MEC, it loses its tax advantages and cannot revert back to a non-MEC status. One important point to note is that beneficiaries don't have to pay taxes on the life insurance death benefit they receive, especially if it's received as a lump sum.
When Was Section 7702 of the Tax Code Written?
Section 7702 and all related subsections were enacted in 1984.
The Bottom Line
Section 7702 is a part of the U.S. tax code. It governs how permanent life insurance policies like whole, term, and universal contracts are treated for tax purposes. Under the rules, these vehicles must qualify as insurance contracts as per the IRS and must pass certain tests, including those for the cash surrender value and premiums. If they don't meet these requirements, the cash value (as well as loans and withdrawals) may be subject to taxation.