7702 Plans vs. 401(k)s [Top Pros and Cons of Each]

Comparing IRC 7702 vs 401k and 529 plans

Which of these vehicles – if any – belong in your financial plan?

When it comes to retirement planning, many people are familiar with the more “traditional” avenues, like employer-sponsored 401(k) plans and Individual Retirement Accounts, or IRAs. But there are some additional options that a lot of investors and retirees are not aware of, even though they have been used for over 100 years…and they could provide some significant tax benefits and guarantees. One of these is the IRC 7702 plan.

What is an IRC Section 7702 Plan and How Does It Work?

Named for a section of the Internal Revenue Code (IRC), the 7702 plan is a specific type of cash value life insurance policy that can be leveraged for various tax advantages – including supplementing your retirement income with tax-free funds.

In many ways, 7702 plans work the same as other permanent life insurance policies. For instance, they are life insurance contracts between a policyholder and the offering insurance company – and, provided that the plans meet certain regulations listed in the tax code, a portion of the premiums paid into a 7702 plan go towards building up cash savings while another portion goes towards the cost of the insurance coverage (i.e., the death benefit).

But, while most people consider purchasing life insurance for the death benefit proceeds it can provide for debt payoff and income replacement, the reality is that these flexible financial tools can be used for so much more – even when the insured is still alive.

Different types of cash value life insurance:

• Whole life insurance
• Universal life insurance
• Indexed universal life insurance
• Variable universal life insurance

Each of these life insurance types use different parameters for how the return in their cash value components are determined. But all allow for the funds in the plan to grow on a tax deferred basis. This means that there is no tax on the gain unless or until the money is withdrawn.

IRA Conversion Strategies with Indexed Universal Life Insurance

In this webinar, we focus on IRA to Indexed Universal Life (IUL) conversions, a strategy that might redefine your retirement planning. Join IUL expert Jason Herring, as he delves into the nuances of converting tax-deferred retirement funds into tax-free vehicles through IULs.

How 7702 Plans Differ from Traditional Retirement Accounts

If your employer offers a traditional 401(k) plan, you have the opportunity to build up a nice nest egg, as well as take advantage of tax-related benefits like pre-tax contributions and tax deferred growth.

For instance, the money that you contribute – up to the annual maximum amount – is not considered taxable income in the year(s) that you contribute. Therefore, with a reduced income base, you can either pay less in income taxes or receive a larger income tax refund during these years.

In addition, because the funds in the traditional 401(k) plan grow tax deferred, you won’t have to pay taxes on the growth until you withdraw the gains. This, in turn, could allow your account value to grow exponentially because you are generating a return on your:

• Contributions
• Previous gains, and
• Funds that would have otherwise been paid in taxes

Traditional 401(k) plans may allow you to do some other things, too, such as:

• Choosing from a variety of different investments (like mutual funds, bonds, and money market accounts)
• Borrow money from the account (although interest will be charged on the borrowed funds)
• Take penalty-free withdrawals for certain types of emergencies

Depending on the company that offers the traditional 401(k) plan, you may also receive “matching” contributions from your employer. The amount of the match is typically determined as a percentage of what you contribute in a given year.

Because many 401(k) plan participants invest at least some of their funds in equities (such as stocks and mutual funds), there is a risk of loss. This could include the erasing of previous gains, as well as losing some (or all) of your contributions.

Many investment advisors tout “average” returns when trying to entice investors to move money into various financial vehicles. But even if a particular investment generates a good average return, you could still come up short.

Take, for instance, contributing $1,000 into an account, generating a 0% (a seemingly “break even”) average return over a 10-year period, but still losing a portion of what you contributed. In fact, any time there is a negative return that is factored into the overall mix, the average return will not equal the actual return on your money.

End of Year	Gain or Loss	Value of Account
1	10%	$1,000.00
2	(-10%)	$990.00
3	10%	$1,089.00
4	(-10%)	$980.10
5	10%	$1,078.11
6	(-10%)	$970.30
7	10%	$1,067.33
8	(-10%)	$960.60
9	10%	$1,056.66
10	(-10%)	$950.99

Source: The Retirement Miracle. By Patrick Kelly

With that in mind, even though many investors take full advantage of the benefits offered through traditional 401(k) plans, there are some “tradeoffs” to be aware of that may impact how you move forward, as well as the amount of money that you will actually have available to spend when you make withdrawals.

401 (k) Drawbacks:

The following are 4 potential hazards to consider when using a 401 (k) plan.

1. Maximum annual contribution limits.

Participants in traditional 401(k) plans are only allowed to contribute up to a certain amount each year. In 2022, if you are age 49 or younger, the most you can put into an employer-sponsored 401(k) is $20,500. If you are age 50 or older, you can add an additional $6,500 in “catch up” contributions, for a total of $27,000. In 2023, these figures will rise to $22,500 and $30,000 respectively. So, what happens in you wish to contribute more so you can obtain more tax-advantaged growth? The 7702 plan can help!

2. Required minimum distribution (RMD) rules.

When a traditional 401(k) plan participant turns 72, they are required to start withdrawing at least a certain amount from the account every year going forward. If they don’t, they will face a financial penalty from the IRS.

3. IRS early withdrawal penalty.

Conversely, if you withdraw funds before turning 59 ½, you could incur a 10% “early withdrawal” penalty from the IRS. This is in addition to any taxes that you owe.

4. Volatility (Sequence of Returns Risk)

Sequence of returns risk is a big concern for those nearing retirement, particularly if they’re heavily invested in market-based assets like 401(k)s. This risk refers to the devastating impact of negative market returns in the early years of retirement. While the average return over time might be positive, the order in which those returns occur can significantly affect your retirement savings.

For example, imagine two retirees with identical portfolios and withdrawal rates, but different market conditions in their first few years of retirement. Retiree A experiences negative returns in the first three years, while Retiree B sees positive returns. Even if their long-term average returns are the same, Retiree A’s portfolio may be depleted much faster due to withdrawing funds from an already diminished account. This scenario can force Retiree A to either reduce their standard of living or risk running out of money.

5. Withdrawals are usually 100% taxable.

Another significant drawback to traditional 401(k)s is that 401 (k) withdrawals are usually 100% taxable. Because you are allowed to contribute money on a pre-tax basis, and the funds in the account grow tax deferred, Uncle Sam will eventually want HIS money – and he would much rather generate tax from an account that has grown substantially over time versus the much smaller contributions that go into the account.

This taxation on withdrawals can actually create a double whammy, as many economists expect income tax rates in the U.S. to rise in the near future…and no one knows how high they will go. But in the past, the top federal income tax rate has been in excess of 90% several times.

So, the more income tax you owe, the less net spendable income you will have available for your retirement. And with the government over $35 trillion in debt, it is not hard to see why taxes will most likely be higher (rather than lower) in the future.

Top Federal Income Tax Rates 1913 – 2022

Year	Rate	Year	Rate
2018-2022	37	1950	84.36
2013-2017	39.6	1948-1949	82.13
2003-2012	35	1946-1947	86.45
2002	38.6	1944-1945	94
2001	39.1	1942-1943	88
1993-2000	39.6	1941	81
1991-1992	31	1940	81.1
1988-1990	28	1936-1939	79
1987	38.5	1932-1935	63
1982-1986	50	1930-1931	25
1981	69.125	1929	24
1971-1980	70	1925-1928	25
1970	71.75	1924	46
1969	77	1923	43.5
1968	75.25	1922	58
1965-1967	70	1919-1921	73
1964	77	1918	77
1954-1963	91	1917	67
1952-1953	92	1916	15
1951	91	1913-1915	7

Source: Tax Foundation

Tax Dominoes

Like a row of dominoes, more taxable income in retirement can affect other cash flow sources, too. For instance, many retirees do not know that up to 85% of their Social Security retirement income benefits could be taxable.

How much these benefits are taxed depends in large part on how much taxable income you generate from other sources – such as a traditional 401(k) plan – as well as when you claim your Social Security benefits.

Based on your situation, you may have to pay tax on a percent of your Social Security benefits (in 2022), if you meet one of the following criteria:

• You file your federal income tax return as an individual taxpayer, and your combined income is:
• Between $25,000 and $34,000 (if so, up to 50% of your Social Security retirement benefits could be taxable)
• More than $34,000 (if this is the case, up to 85% of your Social Security benefits may be taxable)
• You file a joint income tax return with your spouse, and you have a combined income that is:
• Between $32,000 and $44,000 (if so, then up to 50% of your benefits may be taxable)
• More than $44,000 (in this case, up to 85% of your Social Security retirement income benefits may be taxable)
• You are married and you file a separate tax return.

Note that the amount of your combined income is equal to your adjusted gross income plus any non-taxable interest earned, plus one-half of your Social Security benefits.

In addition, the IRS requires you to start withdrawing at least a minimum amount of money from traditional 401(k)s once you turn 72 – and if you don’t follow these required minimum distribution rules, you can be penalized.

Traditional 401(k) Pros and Cons

Traditional 401(k) Advantages	Traditional 401(k) Drawbacks
Pre-tax contributions	Withdrawals are usually 100% taxable
Tax-deferred growth	Required Minimum Distributions (RMDs)
Employer matching contributions	Maximum annual contributions
Ability to borrow funds	Interest charged on loan - and taxed as a distribution if not repaid
Opportunity to generate large returns	IRS 10% early withdrawal penalty if withdrawals are taken before age 59 ½
	Withdrawals may cause taxation of Social Security income
	Can incur market-related risk

Contrast this with a 7702 Plan

This is where the 7702 plan can provide you with some significant benefits – including the ability to access funds tax free from the policy’s cash value component. Depending on the then-current income tax rates, this feature alone could allow you to put much more money towards your living expenses in the future.

Policyholders can usually access cash from permanent life insurance plans. One way is through withdrawals. But, similar to with the traditional IRA, when the tax deferred gains are accessed via withdrawals, they will be taxable.

Another option for accessing cash from a cash value life insurance policy is through a loan. Although some people are uncomfortable with borrowing money, a life insurance loan could provide several enticing benefits.

Life Insurance Loans Are Not Taxable

For instance, life insurance loans are not taxable. Therefore, you will be able to use 100% of the funds from the loan for whatever you need or want. Plus, these loans are actually from the insurance company, and they simply use the cash in your policy as collateral (versus borrowing directly from the cash value). Because of that, 100% of your cash value funds will still be generating interest.

As an example, if you have $80,000 of cash value in a whole life insurance policy, and you borrow $40,000, interest will continue to be generated on $80,000.

As an added bonus, even though the insurer will charge interest on the loan, if the funds are not fully repaid at the time of the insured’s passing, the remaining balance of the loan will be paid off using the death benefit proceeds (with the remainder of the money then going to the beneficiary).

Life Insurance Gains are Tax Deferred

Similar to traditional 401(k) plans, the funds that are in a 7702 plan grow tax deferred. So, the build-up of account value can snowball – especially over time. If the policy is structured properly, there are ways to enhance the growth of the cash value in a 7702 plan even more.

For instance, a paid up additions rider is a mechanism that is used to put additional dollars into a dividend paying whole life insurance policy in order to increase the performance of the cash value. In this case, every dollar of premium that is allocated to the paid up additions rider creates a small “paid up” insurance policy that has its own cash value that is created right away.

With that in mind, a whole life insurance policy that has a substantial portion of its total premium payment allocated to paid up additions will usually outperform those that do not take advantage of paid up additions.

Additional 7702 Plan Benefits

• No maximum annual contribution limits
• No required minimum distribution (RMD) rules
• Tax-free policy loans have no impact on the taxability of your Social Security retirement income benefits
• Protection from creditors and bankruptcy (in some states)
• Self-completion (i.e., if the insured dies, the death benefit proceeds are received income tax free by the beneficiary, and they can be used for their originally intended purpose and/or other needs and wants)

Because certain cash value life insurance policies protect principal in any type of market or economic environment, you generate a nice profit over time – and without worry about what is happening with the stock market. With whole life insurance you have a non-correlated asset and with index universal life you have a 0-1% floor to protect against market losses.

2% Compound Return, Tax-Deferred for 10 Years

[Initial Account Value = $1,000]

End of Year 1	$1,020
End of Year 2	$1,040
End of Year 3	$1,061
End of Year 4	$1,082
End of Year 5	$1,104
End of Year 6	$1,126
End of Year 7	$1,149
End of Year 8	$1,172
End of Year 9	$1,195
End of Year 10	$1,219

Given the many advantages of 7702 plans, there are a few potential drawbacks to be mindful of, such as:

• No income tax deduction for contributions
• The cash value might initially build up slowly
• Surrender penalties on withdrawals in the early years of the policy
• Gains that are withdrawn are taxable
• The insured must qualify for the life insurance coverage

Because not all life insurance policies are the same, it is essential to work with a professional who is well-versed on how a cash value life insurance policy could be used to supplement your retirement plan.

So, before you make a long-term commitment to a plan – which could cost a significant amount in surrender charges if you later cancel the policy – it is recommended that you contact an expert in this area who can narrow down which plan, if any, is right for you.

Pros and Cons of 7702 Plans

7702 Plan Advantages	7702 Plan Drawbacks
Cash value grows tax deferred	No income tax deduction on contributions
Funds can be "borrowed" tax free	Surrender penalty on early withdrawals (during the surrender period)
No annual maximum contribution limits	Usually charge interest on borrowed funds
Can "repay" a policy loan balance with death benefit proceeds (after the insured passes away)	Cash value could become taxable if "too much" premium is contributed to the policy
Beneficiary(ies) can receive the death benefit income tax free	The insured must be able to qualify for the policy based on their health condition
The premium amount will oftentimes remain the same for the life of the policy	Without paying the premium, the policy could lapse
No required minimum distributions (RMDs)	May take time for the cash value to build up
No 10% IRS "early withdrawal" penalty if under age 59 ½
Protection from creditors / bankruptcy (in some states)

Case Study: Sarah’s Retirement Planning Decision

Sarah is a 35-year-old marketing executive earning $100,000 per year. She’s looking to maximize her retirement savings over the next 30 years. Let’s compare her options: a traditional 401(k) and a 7702 plan (high cash value life insurance) for use with the infinite banking concept.

Scenario 1: 401(k) Plan

• Sarah contributes $20,500 annually (2024 limit)
• Her employer matches 50% of the first 6% of her salary ($3,000)
• Total annual contribution: $23,500
• Assumed average annual return: 7% (before fees)
• Fees: 1% per year
• Net annual return: 6%
• Current tax bracket: 24%
• Assumed tax bracket at retirement: 32% (accounting for potential tax increases)

After 30 years: Using the compound interest formula: FV = P * (1 + r)^n + C * ((1 + r)^n – 1) / r Where P = 0, r = 0.06, n = 30, C = 23,500

Account balance at age 65: $2,007,441 After paying taxes (32%): $1,365,060 (spendable amount)

Scenario 2: 7702 Plan with Infinite Banking

• Sarah contributes $24,000 annually
• Assumed average annual return: 5% (guaranteed cash value growth plus dividends)
• No market volatility risk

Base 7702 Plan Growth: Using the same formula: FV = P * (1 + r)^n + C * ((1 + r)^n – 1) / r Where P = 0, r = 0.05, n = 30, C = 24,000

Cash value at age 65: $1,635,156

Infinite Banking Strategy:

1. At age 45 (10 years into the plan), Sarah’s cash value has grown to approximately $320,000.
2. Sarah takes a $100,000 loan from her policy to invest in a rental property.
   • The policy continues to earn 5% on the full $320,000 cash value.
   • Sarah’s loan has an interest rate of 5% which she pays back to the policy.
3. The rental property provides an average annual return of 8% (through appreciation and rental income).

Calculation for the real estate investment over 20 years: FV = 100,000 * (1 + 0.08)^20 = $466,096

Total Assets at age 65:

• 7702 Policy Cash Value: $1,635,156
• Real Estate Investment Value: $466,096 Total: $2,101,252 (accessible tax-free through policy loans)

Additional benefits of the 7702 plan:

1. Flexibility: Sarah can access her cash value at any time without penalties.
2. Death benefit: Provides additional financial security for Sarah’s family.
3. Tax-free growth and withdrawals: Sarah’s retirement income doesn’t increase her tax bracket.
4. No RMDs: Sarah isn’t forced to take distributions at age 72.
5. Ability to leverage policy for other investments (infinite banking).

Comparison at Retirement:

1. 401(k) spendable amount: $1,365,060 (after taxes)
2. 7702 plan with infinite banking: $2,101,252 (tax-free via loans)

Long-term considerations:

1. Tax uncertainty: If tax rates increase more than anticipated, the 7702 plan becomes even more advantageous.
2. Market volatility: The 401(k) is subject to market risks, especially concerning sequence of returns risk near retirement.
3. Flexibility: The 7702 plan allows Sarah to adapt to changing financial needs throughout her life.
4. Legacy planning: The 7702 plan’s death benefit provides additional value for estate planning.
5. Wealth-building potential: The infinite banking strategy allows for leveraging the policy to build wealth through other investments.

Conclusion: In this case study, the 7702 plan with the infinite banking strategy provides Sarah with significantly more wealth at retirement compared to the 401(k). It offers greater flexibility, tax advantages, protection against market volatility, and the opportunity to leverage the policy for additional investments. However, it’s important to note that this strategy requires careful planning and execution.

The choice ultimately depends on Sarah’s risk tolerance, desire for flexibility, and overall financial goals. A balanced approach using both strategies might be optimal, allowing Sarah to maximize her employer match in the 401(k) while enjoying the benefits of the 7702 plan and infinite banking.

Benefits of 7702 Plans – Both Before and After Retirement

In addition to accessing tax-free retirement income, there are other areas where the 7702 plan can also be beneficial, such as college funding. The cost of a college education can be daunting, so it is important to start as early as possible when saving for this expense.

529 Plans

Many families opt to use a 529 plan when saving money for a child, grandchild, or other loved ones’ future college costs. These are state-run plans where you can invest in a selection of mutual funds.

The earnings in the account grow tax deferred, and provided that the withdrawals are used for education-related expenses, they are tax free. Depending on the state, you could also receive a tax deduction or credit for contributions to a 529 plan.

529 Plan Disadvantages

Although 529’s are popular college savings plans, though, they have a couple of drawbacks. First, because the money is often invested in equities like mutual funds, there is the chance that prior gains and contributions could be lost if the market or investment turns south.

In addition, if the donor / contributor to a 529 plan suddenly passes away, there is no guarantee that enough funds will be available for the beneficiary when he or she is ready to go to college.

That’s why a strategy for college savings (or to supplement savings for college) is to purchase a cash value life insurance policy. These policies offer a cash value component that grows tax deferred. Money may also be accessed tax free through a policy loan.

Cash Value Life Insurance vs. 529 Plans for College Saving & Funding

Cash Value Can Be Used for Anything

But unlike the 529 plan, there is no requirement that the life insurance cash value be used for college-related costs. In fact, the money that is either borrowed or withdrawn from a cash value life insurance policy can be used for anything. Therefore, if the potential student decides not to attend college in the future, there are no “penalties” when accessing the life insurance cash value.

Further, the cash value of whole life and indexed universal life insurance policies won’t be reduced – even in the event of a stock market correction. So, because the principal – and the previous gains – are all locked in, there is no concern about the account losing value in the future.

Unlike a 529 plan, life insurance won’t impact any financial aid that the student may be applying for. This is because the cash surrender value is not considered as an eligible asset when determining the expected family contribution for need-based financial aid when submitting the federal government’s form, Free Application for Federal Student Aid, or FAFSA.

A cash Value life insurance policy is also considered to be a self-completing plan. This means that if the insured passes away – even if they have only made one premium payment into the policy – the beneficiary will receive the tax free death benefit. Therefore, the insured individual can make sure that even if the unexpected is to occur, the beneficiary will still have the money that they need for their future education costs.

7702 vs. 529 College Savings Plan

	7702 Plan	529 Plan
Tax-deductible contributions	No	Maybe (depending on the state)
Tax deferred growth	Yes	Yes
Guaranteed amount of money if the donor / contributor passes away	Yes	No
Principal and previous gains are protected	Yes (with whole and universal life insurance)	No
Tax free withdrawals	Yes (through a policy loan)	Yes (but only if used for education-related expenses)
Can impact eligibility for financial aid	No	Yes

Are You a Good Candidate for a 7702 Plan?

While IRC 7702 plans can offer many enticing benefits, they are not suitable for everyone. However, a 7702 plan may be a good option if you:

• Are seeking more tax free income in retirement
• Have “maxed out” the annual contributions to your 401(k) and/or other qualified retirement plan(s) and want additional tax advantaged growth
• Would like principal protection in any type of stock market environment
• Want to use certain benefits while living
• Do not want to make up for losses before generating gains again
• Want the assurance of the death benefit so that finances are still covered – even in the event of the unexpected
• Do not want additional income that could cause your Social Security benefits to be taxable
• Don’t want to be forced to withdraw money at age 72 (nor be penalized if you don’t do so)

How to Find the Best 7702 Plan

Although 7702 plans can be a nice compliment to your other retirement savings, these vehicles should not be used to completely replace them. Rather, it is recommended that you look at your overall financial picture – including short- and long-term objectives, potential tax situation, and other retirement income generators – and from there design a plan that works for you.

At Insurance and Estates, we focus on assisting consumers with protecting what they have worked for, while at the same time helping them to reduce – or even eliminate – taxable income and withdrawals in retirement.

So, if you would like to set up a time to talk with one of our Insurance and Estates specialists, feel free to call us directly at (877) 787-7558 or send us an email via our secure online contact form by going to info@insuranceandestates.com. We look forward to helping you reach your retirement goals.