What is Section 7702?
Section 7702 of the IRS tax code outlines the guidelines for determining whether a life insurance contract qualifies as a tax-favored contract and sets limits on the premiums that can be paid on such a contract and the amount of death benefit that can be paid out.
There are three tests that a policy must pass in order to qualify for favorable tax treatment:
Cash Value Accumulation Test (CVAT)
The CVAT states that the cash surrender value of a policy cannot exceed the premiums paid for the policy, excluding fees.
Guaranteed Premium Test (GPT)
The GPT determines whether a policy can be taxed as an investment or a life insurance contract, and sets limits on the amount of money that can be contributed to a policy relative to the death benefit.
Modified Endowment Contract (MEC) Premium Limits
The MEC premium limits prevent policies from being classified as a MEC, which can take away the tax benefits of a permanent life insurance policy, by limiting the amount of premiums that can be paid in the early years of the policy.
Previously, the CVAT calculation was based on a 4 percent requirement, but in 2021 it was changed to a 2 percent requirement. This change enables policyholders to fund more tax-efficient growth in the cash value of a policy without increasing the death benefit.
When Section 7702 was first enacted in 1984, it required insurance carriers to provide a minimum guaranteed interest rate of 4 percent. However, when interest rates eventually increase, it is possible that Section 7702 could change back. It is important to note that the minimum guaranteed interest rate is specific to each policy at the time of issue, so policies already in force would not be negatively impacted by any future changes to the law.
What does this mean for you and your life insurance policy?
Section 7702 simply directs the minimum guaranteed interest rate insurance carriers need to use for all new contracts. The lower the rate, the higher the premium they can charge, but the greater the policy funding that becomes permissible within the IRS’ definition of a life insurance policy, that carries unique tax advantages.
Permanent life insurance has long been used as a tax-efficient planning tool for the wealthy. The changes to Section 7702 provide an opportunity for high income earners to dramatically enhance the efficiency of those benefits.
A Quick Summary
For policyholders, the changes to Section 7702 may make life insurance policies with a cash value accumulation element more attractive, as they may be less likely to be classified as a MEC and subject to tax consequences or penalties when taking a distribution. It is important to speak with an experienced licensed insurance agent who is knowledgeable about these changes and how they may impact your decision to purchase one of these policies.