Today we’re going to delve into 7702 plans and provide a thorough explanation covering the good, the bad, and the ugly aspects. We’ve been receiving numerous inquiries at our office from individuals who have been exploring social media content about different infinite banking concepts. Some of this information is accurate, while some isn’t quite on point.
There’s no magic solution when it comes to account growth and utilization. At its core, these plans are simply overfunded cash value life insurance policies. They allow you to utilize the cash value to grow your money tax-free, withdraw funds tax-free, and upon passing, leave a legacy or death benefit to your loved ones in a tax-free manner.
1. Potential Pitfalls
While these components sound appealing, implementing this plan incorrectly or for the wrong reasons could be disastrous. A potentially catastrophic situation would involve investing thousands of dollars into unsuitable accounts with carriers that offer limited growth potential. These might have long surrender schedules, meaning that if you attempt to withdraw funds within the first several years, you’ll face surrender penalties that could last 10-15 years.
Perhaps most critically, insurance agents might incorporate substantial expenses into these accounts if they structure them improperly. The key concept is to properly structure your plan and ensure the benefits align with your retirement goals. These accounts can serve as an efficient component of your ultimate retirement strategy, but caution is necessary.
2. Basic Concept
From a 30,000-foot view, a 7702 plan involves setting aside money, either through monthly contributions or a large lump sum. This approach is particularly suitable for individuals with cash accounts that aren’t generating significant interest who want their money working harder for them, but who are risk-averse and prefer not to be exposed to market volatility. From a taxation standpoint, this can be an excellent scenario.
What happens is that an individual makes contributions into this product (we call it an account or product). When someone leverages permanent life insurance, they’re paying a premium that goes into a policy. This policy contains a combination of insurance costs and a savings component known as cash value.
3. Death Benefit and Risk
The insurance cost is determined by the death benefit. For example, if someone contributes $1,000 monthly with a death benefit of $500,000, perhaps $900 goes toward insurance costs, leaving $100 for the cash value. Conversely, with a $100,000 death benefit, perhaps $800 goes into cash value and only $200 toward insurance costs.
This difference exists because the risk varies. The net amount at risk to the insurance company differs significantly between $500,000 and $100,000 death benefit coverage—that’s a $400,000 difference. If someone makes one premium payment and then suffers a fatal accident, the insurance company must pay $500,000 tax-free to the beneficiaries, representing a substantial loss.
Insurance companies manage this through actuarial data and the law of large numbers. As new premiums come in and older policyholders pass away, they invest these funds in their general accounts. Understanding the actuarial data on life expectancy allows them to generate profit. Ultimately, it comes down to the underwriting of an individual’s health and the death benefit coverage, which determines the net amount of risk.
4. Proper Structure Strategies
The first key strategy with these policies, when properly structured for someone trying to grow their cash value (the savings component), involves a simple concept: Should you increase the death benefit, which leads to higher costs, or decrease it to reduce costs while maintaining the same premium payment?
The obvious answer is the latter scenario—the smaller death benefit results in less risk to the insurer. To explain more clearly: If $1,000 goes in and you have a $500,000 death benefit, a significant portion covers insurance costs and expenses, leaving less for cash value. By reducing the death benefit to $200,000, that same $1,000 premium results in lower insurance costs and more dollars flowing to cash value accumulation.
This occurs because we’re focusing on reducing the net amount at risk. To maximize cash value accumulation, we would aim to reduce the death benefit as much as possible. However, be mindful that there must be a correlation (known as the cash value corridor) between your cash value growth and death benefit.
5. IRS Compliance
The term “7702 plan” comes from Internal Revenue Code 7702, which requires maintaining a minimum death benefit to prevent the policy from becoming a modified endowment contract (MEC). This compliance allows your cash value to maintain its tax-favorable status—tax-free growth, tax-free withdrawals, and a tax-free death benefit.
This represents the fundamental strategy behind properly structured 7702 plans. Whether you’re systematically contributing for 10-30 years or allocating large lump sums (such as $100,000 per year from a $500,000 fund over five years), the principle remains: maintain the smallest allowable death benefit so your cash value can accumulate at the highest possible rate.
6. Product Types
While different product lines leverage this strategy, not all are effective—in fact, most are subpar. By reducing the net amount at risk, insurance costs, and other expenses, you maximize the dollars flowing into your account. The other critical factor is how the cash value grows, which depends on the policy type.
With whole life insurance, the rate of return is more fixed. Insurance carriers pay into the cash value through dividends, essentially returning a portion of your premium. Universal life, popular in the 1980s, ties growth to interest rates. Unfortunately, with interest rates having fallen to historic lows (though they’ve increased recently), these policies may underperform significantly compared to the 20-22% returns some expected decades ago.
Variable universal life leverages sub-accounts similar to mutual funds, offering potential for positive returns but also risk of negative performance. Our preferred option is often indexed universal life (IUL), which can generate positive returns when linked market indexes rise, but provides a 0% floor when markets decline.
We typically favor indexed universal life over whole life due to its flexibility. Whole life has many fixed elements and a fixed rate of return, while IULs offer more variability and higher potential returns with downside protection through the 0% floor.
7. Tax Benefits
A properly structured 7702 plan sounds compelling: tax-free growth, tax-free withdrawals, and a tax-free death benefit for beneficiaries. From a taxation perspective, it can be an excellent tool for risk-averse investors who want to outpace inflation without market exposure. It can serve as an inflation hedge when viewed long-term.
Common mistakes occur when people try to use these as “jack of all trades” products—contributing for a couple years, then borrowing against the policy to purchase a car or fund other expenses. This approach prevents the plan from properly maturing. Used correctly, it serves as a tax hedge, inflation hedge, market-loss hedge, and expense hedge. While these plans can be costly when improperly structured, they become advantageous with the right product, scenario, and time horizon.
8. Retirement Planning Integration
Consider your retirement goals. If you’re in your 20s-40s planning to retire at 60 or earlier (before the 59½ age threshold for traditional accounts), these plans offer a solution. You might contribute to your employer’s 401(k) for matching funds, but also allocate to these properly structured IUL or cash value 7702 plans for growth.
This enables a strategic income approach: perhaps drawing from your cash value plans between ages 55-60, then accessing traditional retirement accounts after 60, triggering Social Security at 62, and implementing additional income strategies at 67.
The most common mistake occurs when people utilize 7702 plans with too short a timeframe, insufficient contributions, and unrealistic growth expectations. Think of this as the tortoise rather than the hare—slow, methodical, and safe. It’s not an exciting investment vehicle for explosive growth; rather, it provides an additional safety layer in your retirement strategy.
9. Four Pillars of Retirement Planning
Effective retirement planning addresses four crucial areas: distribution strategies, investment/growth strategies, estate planning strategies, and tax planning strategies.
Distribution Strategies
If you’re 10-20 years from retirement, you can adopt this slower, methodical approach by allocating discretionary monthly funds toward building assets for your ideal retirement date. Consider this practical scenario: when retirees collect Social Security income alongside distributions from qualified assets like 401(k)s or traditional IRAs, their provisional income may increase, potentially raising the taxation on their Social Security benefits.
By incorporating a 7702 plan and taking tax-free withdrawals, you avoid impacting that provisional income calculation under current tax laws. This means you could potentially receive more net income from Social Security while enjoying a secondary, tax-efficient cash flow strategy.
Investment Strategies
From an investment or growth perspective, these plans offer value if you want to set aside money without exposure to market volatility. Perhaps you already have market-based investments that fluctuate with positive and negative returns, and you desire something more consistent as a complement.
Estate Planning Strategies
Regarding estate planning, these plans provide a tax-free death benefit to your beneficiaries. While the death benefit is typically less emphasized when establishing a properly structured IUL or 7702 plan, it remains significantly more favorable than leaving a simple account balance.
Tax Planning Strategies
The taxation advantages—tax-free growth, tax-free income, and tax-free death benefit—encompass all four critical areas of comprehensive retirement and financial planning.
10. Common Mistakes
The most common mistake is working with an advisor unfamiliar with these plans, perhaps one who simply follows a marketing representative’s pitch without proper understanding. Instead, seek an advisory group thoroughly versed in these products, capable of offering all available plan types and identifying which best suits your specific situation—considering your state, age, and time horizon. They should openly discuss both pros and cons, because if the plan still stands after rigorous scrutiny, it might be a favorable asset for your portfolio.
Conversely, if your time horizon is too short or your contribution amount isn’t mathematically sufficient (resulting in excessive costs that erode benefits), these plans may be inappropriate for you.
Carrier Selection
The insurance company selection is critical—in a given state, there might be 110 different carriers offering these products, but perhaps only two provide truly excellent options. Your advisory team should carefully select the best company for your specific needs.
Index Considerations
Pay close attention to index caps—one company might offer an S&P 500 index with a 12% cap, while another limits returns to 6%. If the S&P 500 gains 15% in a year, the first account would credit 12% to your cash value, while the second would only credit 6%. In a negative market year, both would provide 0% (protecting your principal), but in a 10% positive year, the first would credit 10% while the second remains capped at 6%. Over just three years, this could mean a 22% cumulative return versus only 12%—a significant difference due to the cap limitation. Some indexes are uncapped or use algorithms that reduce volatility for more consistent growth.
Structuring and Implementation
The plan structure varies depending on whether you’re contributing monthly discretionary funds or investing a large lump sum that’s currently sitting in a bank earning minimal returns. The structuring and funding work hand-in-hand—utilizing the smallest allowable death benefit to maximize cash value accumulation by reducing the net amount at risk and cost of insurance.
Implementation strategy is the final piece—determining whether to let your plan grow indefinitely or calculate a specific income stream starting at age 60 and continuing through age 100, potentially incorporating it into a broader income laddering strategy.
Our Approach
We differentiate ourselves by understanding the intricacies of these IUL and 7702 plans, working with them regularly for clients seeking second opinions or implementation assistance. Our approach involves thoroughly challenging the concept first—if it remains viable after scrutiny, we’ll recommend it. If concerns persist, we won’t suggest it to members or clients.
There are many instances where we advise against placing money into 7702 plans when they wouldn’t be mathematically beneficial. That’s the primary issue with the growing popularity of “infinite banking” concepts—while they can be successful, caution and careful analysis of potential negatives are essential to determine whether benefits outweigh drawbacks.
Conclusion
If mathematical benefits exist and the plan serves as a valuable addition to your overall portfolio—providing an additional resource bucket—that would be ideal. But we always recommend caution when establishing these plans. We maintain an entire division focused on these products because of the insurance industry’s tendency toward complexity, though we have also witnessed excellent outcomes when implemented correctly.
For those with specific questions or interest in exploring these options further, we offer personalized assistance in finding the appropriate carrier and implementing a plan tailored to your needs.
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