You may have heard or seen advertised something called a 702(j) retirement plan. Can you set one up with your bank or your brokerage account, or through your employer?
Is it because, as some of the advertisers claim, “the government” doesn’t want you to know about it, as it is some sort of elite investment to which only celebrities and wealthy people have access?
What Is a 702(j) Retirement Plan?
Simply put, a 702(j) retirement plan doesn’t exist.
It isn’t a retirement plan, like a 401(k) plan or an IRA or Self-Employed IRA. It is another name for a permanent life insurance policy. The reason it sounds like other plans is because it is named after Sub-Section 7702 of the U.S. Internal Revenue Code dealing with life insurance contracts. It is an insurance contract.
Often, people are familiar with the 401(k), which is also from a subsection of the Internal Revenue Code. It was begun in 1978, and allowed corporations to provide tax-deferred retirement investment accounts to employees.
Some advisers use the familiarity of the term "401(k)" to get potential customers to consider life insurance policies as connected to retirement plans. In other words, a “702j” or “7702 Plan” or even a “7702 Private Plan” sounds like a retirement plan, but isn’t.
You can have life insurance investment connected to an IRA, or even a 401(k). But it isn’t a plan or an account.
How Does a 702(j) Plan Work?
A life insurance policy is a contract between the investor and a company. The marketing of a life insurance policy as a kind of savings and investment plan is a means of getting people to buy an insurance policy.
This is a major, important difference between retirement plans and an insurance product. A 401(k) or IRA is an account that contains assets you own, on deposit for you by an institution. A life insurance policy, on the other hand, is a contract between you and an insurance company.
Because a company is taking a risk with you, as opposed to your investing in a company and taking on the risk, most terms for the insurance are set at the start, and favor the company – and you can’t change them.
Generally speaking, insurance contracts are designed to provide profits to an insurance company and their sales staff – you pay a premium every month for protection (a death benefit, in the case of life insurance) – that the company agrees to pay when or if you die before the insurance coverage expires.
The contracts themselves are extremely profitable, providing high commissions for sales – and an incentive to financial services of all kinds to sell them.
But, again, generally speaking – a profitable product for an insurance company is often not that great a deal for an investor.
According to financial guru Suze Orman, “Insurance was never meant to be a permanent need. It was only meant to be there in case something happened to you when your children were young,” so that their needs could be provided for in the event of your early demise, before your assets built up.
For people with young children, Orman recommends a 20-year term life insurance policy, which can be had for far less monthly premiums than a whole life or variable life insurance policy, and for parents to pay on it until their youngest child is 23 years old.
The reasoning is, besides covering an adult for a set period of time, as opposed to open-ended, the premiums on a term life insurance policy is usually about 1/20 the cost of “cash value” or whole life insurance, according to David Ramsey.
As an example, instead of paying $100 a month in premiums for a whole life policy, you would spend $5 a month for a term policy.
The additional $95 a month paid for a whole life policy goes to an account to be saved as “cash value.” That money is making very low return - if you're lucky, 1%. To get your money out of the policy, you either have to cancel the policy, or borrow your own money at interest, Ramsey notes. And, even with a death benefit, if you’ve paid into the policy, monthly, say $500, for a $100,000 death benefit, you’ve paid (and could have saved) $120,000. But the insurance company gets to keep the $20,000 more you paid, as the death benefit is fixed at $100,000.
But don’t cancel a 702(j) or 7702 or even a whole or variable life insurance plan until you have a term life insurance policy in place.
What Are the Benefits of a 702(j) Plan?
Again, generally speaking, if you want to save for retirement, you’d do better to set up a more traditional retirement account or even a life insurance plan instead, according to retirement planner and financial adviser Thomas Rockford, writing about life insurance for LifeAnt.com.
The reason 7702 (or 702(j)) plans are marketed as a means of building cash savings is because they do have a savings component.
When you pay the life insurance premiums on your 7702 plan, the premiums go toward your death benefit and the policy’s cash value. The cash value can then be invested – helping it to grow. The gains on the cash value of the insurance are tax-deferred, and you can actually withdraw from it in emergencies after a few years.
When you die, your beneficiaries will receive both a death benefit and any of the cash value remaining. If you reach the point where you no longer need life insurance, you can cash it out and use your funds for whatever you like.
The 702(j) lan is usually another term for a whole life or “permanent” life insurance policy, for which you build cash value by paying more than is necessary for the coverage. You can borrow against this “overfunding” or cash value – and, while there may be an interest charge to borrow from it, such loans are tax-free.
In addition to being tax-free, such loans don’t need to be paid back while the policyholder lives. They can be paid back from the death benefit paid to a beneficiary after the policyholder dies.
Often, advisers such as Suze Orman recommend buying term life insurance, as it costs far less, even for the same death benefit, and use the remaining cash that would have been required for a whole life policy to invest in the stock market.
This is because, historically, the stock market has returned about 12% a year on average. So the possible return on an investment portfolio, even a conservative one, is higher than the dividend payments on whole life policies.
The investor will enjoy the same amount of life insurance coverage for the term of the coverage, and make more from investing what would be the cash value savings.
By comparison, a whole life insurance policy will grow also, over time – without being as subject to the whims and volatility of the stock market. As long as the premiums are paid, and loans and withdrawals aren’t taken from the policy, its value will grow every year.
In addition, life insurance companies are held to strict capital requirements, and state governments often provide protection to consumers to both the cash value and death benefit of a policy, making it far less risky than market investing.
Lastly, the odds of an insurance company becoming insolvent are far lower than that of a business that sells stock.
In an ideal world, an investment account will grow greater than the death benefit from an insurance policy, making either term or whole life insurance policies unnecessary.
Disadvantages of a 702(j) Plan
If you borrow from your policy, however, and don’t repay the loan while the policy is in force and you’re alive, investment gains on top of what you paid in that you borrow could become taxable, and as such a lone, when you die, will be paid off from the policy’s death benefit, the amount your beneficiaries receive from the death benefit can be reduced or even eliminated. And interest could accumulate on an outstanding loan balance.
Also, much of your premium not used for the policy and not put into build your cash value can be consumed by high commissions and fees.
702(j) Plan vs. 401(k) and IRAs
There is no way a 702(j) plan – again, an insurance policy – is a better means of saving for retirement than an 401(k), even though it sounds like a similar product. That’s because in most cases an employer offering a 401(k) plan also matches with a certain ratio an employee’s contribution to their own plan.
Also, making contributions to an IRA or 401(k), while there are limits, can be tax-deductible. And the growth can be tax-free on a Roth IRA.
What Is a 401(k) Plan?
Unlike a 702(j) Plan, which is really a whole life insurance policy, not a plan at all, a 401(k) plan is tax-advantaged, and has defined contributions offered by employers to employees. Like a 702(j) plan, the 401(k) is named after a subsection of the Internal Revenue Code.
Workers contribute pre-tax dollars to their 401(k) plan through automatic withholding, and employers can match some or all contributions.
The capital gains on investments in a 401(k) aren’t taxed until the employee withdraws the money, usually after retirement.
In a Roth 401(k), withdrawals can even be tax-free.
What Is an IRA?
An IRA is an Individual Retirement Account.
A traditional IRA allows individuals to put money aside from their pre-tax income into investments that can grow with taxes deferred.
Until the beneficiary makes a withdrawal, the IRS won’t assess capital gains or dividend taxes.
Contributions to an individual’s IRA may be tax-deductible depending on the taxpayer’s income and tax-filing status.
A traditional IRA can be opened through a broker, and even a robo-adviser or a financial adviser.
So next time a financial adviser tries to interest you in a 702(j) plan, tell them you’d rather learn about opening an IRA, or buy term life insurance.