Find out how IRS Tax Code 7802 impacts your life insurance coverage. Get tax deductions and benefits for estate planning.

Learn about the requirements for an insurance policy that covers life to be tax-advantaged in Section 772. Avoid paying taxes on loans and withdrawals made from your insurance policy.

Find out whether your life insurance plan conforms to the IRS requirements for growth tax deferred. Protect your beneficiaries from taxation on the death benefit.

What Is Section 7702 of the Tax Code?

Section 7702 is a provision of the Internal Revenue Code that limits the premiums you can put into the life insurance policy without being considered a tax-deductible investment.

If you pay too much into the policy, any withdrawals or loans you take from the cash value may be subject to tax and penalties, but the death benefit is tax-free. If you remain within the limits set by code 7702, your insurance policy offers tax-free advantages.

The tax code 7702 requirements ensure that life insurance coverage is primarily intended to be a death benefit payout out and not an investment tool.

Under Section 7702, Life insurance policies must satisfy two conditions to be tax-favored:

• This policy should be a “life insurance contract,” as the IRS defines it.
• The policy must pass either the cash value assessment test (CVAT), guideline premium, or the test for corridors (GPT).

Tax code 7702 applies to life insurance policies with cash value policies but not to the term-life insurance policy.

Why Is the 7702 Tax Code Important?

Do you need help determining if your life insurance policy meets the standards in Section 7702? You can check your policy’s status by calling your life insurance broker and asking for Daniel Adams, founder and president of CEG Life Insurance Services.

“When you first purchase a life insurance policy, you can specifically request that your policy remains in compliance with Section 7702,” Adams advises. If you decide to increase your premium, Adams recommends consulting with an insurance professional who is qualified to determine if the increase will affect the lawfulness of your policy under Section 7702.

Requirements To Qualify for Section 7702 Tax Code

To comply with tax code 7702, the life insurance policy must pass two tests: the cash value accumulation (CVAT) test and the GPT, a premium and corridor test guideline.

According to Adams, the policyholder can choose the type of test they’d prefer to take and typically select this test when they submit their application.

The Cash Value Accumulation Test (CVAT)

The CVAT decides if the prices put into the life insurance policy are fair compared to the benefits provided. This, in turn, assures that the policy isn’t being used only to serve as a tax shelter.

• Advisor
• Life Insurance

IRS Tax Code 7702: How It Affects Your Life Insurance Policy

Cassidy Horton

Contributor

Ashlee Tilford

EditorFact Checked

Updated: Aug 11, 2023, 4:49 am

Editor’s Note: We receive an income from links to our partners to Forbes Advisor. Commissions are not a factor in the opinions of our editors or opinions.

Internal Revenue Service (IRS) Tax Code 7702 provides the guidelines to determine the taxation status of the universal life, whole life, and other permanent life insurance forms. If the policy you purchase doesn’t satisfy the standards of Code 7702, then you could be liable for taxes and penalties on the loans you take out and withdrawals from the policy’s cash value.

What Is Section 7702 of the Tax Code?

Section 7702 is a provision of the Internal Revenue Code that limits the amount of insurance premiums you may pay for a life insurance policy without being considered a tax-deductible investment.

If you have a high amount in your insurance policy, the withdrawals or loans you take from the cash balance could be subject to taxation and penalties, but the death benefit remains tax-free. But, if you stay within the limits set by code 7702, your insurance policy offers tax-free advantages.

The 7702 tax code regulations are intended to ensure that life insurance coverage is used primarily to pay a death benefit, not as an investment instrument.

Under Section 7702, the life insurance policy must satisfy two conditions to be tax-advantaged:

• This policy should be a “life insurance contract,” as the IRS defines it.
• The policy must pass either the cash assessment test (CVAT) and the guideline price or test for corridors (GPT).

Tax code 7702 is applicable for Life insurance with cash value but not for Life insurance with a term.

Why Is the 7702 Tax Code Important?

Are your insurance policy in compliance with the requirements in Section 7702? You can confirm your policy’s status by calling your life insurance broker, according to Daniel Adams, founder and president of CEG Life Insurance Services.

“When you first purchase a life insurance policy, you can specifically request that your policy remains compliant with Section 7702,” Adams advises. Suppose you decide to increase the amount of premiums. In that case, Adams recommends consulting with a qualified insurance professional to determine if a rise will affect the policy’s compliance with Section 7702.

Requirements To Qualify for Section 7702 Tax Code

To be tax-compliant under the tax code 7702, Life insurance policies must be able to pass one of two tests, which are the test for cash value accumulation (CVAT) as well as the GPT, which is a guideline for the premium and corridor test (GPT).

According to Adams, the policyholder can choose which test they’d prefer to take and typically choose this option after they’ve completed their application.

The Cash Value Accumulation Test (CVAT)

The CVAT examines whether the amount put into the life insurance policy is fair compared to the benefits offered. Also, it ensures that the policy isn’t only used as a tax shelter.

The test evaluates the amount of premiums deposited to the policy and then evaluates the amount to its cash value. When the value of cash is greater than the amount of premiums needed to fund the policy, the policy violates the test and will be removed from tax-deferred status.

Under the CVAT, the policy you choose to purchase must not build up the value of cash too rapidly. If it does, it will be regarded as an investment vehicle instead of an insurance policy. As such, you won’t be able to benefit from the tax advantages provided under Section 7702.

The Guideline Premium and Corridor Test (GPT)

The other test is the Guideline Premium and Corridor Test (GPT). It is designed to verify that your insurance policy is within certain limitations about premiums paid and death benefits.

The GPT includes two parts. The first is it is the Guideline Premium Test and the Corridor Test.

• A Guideline Premium is the highest amount that can be put into a plan without becoming a modified endowment contract (MEC). An MEC is an insurance policy for life that is overfunded and does not meet the criteria for a life insurance policy as defined by the IRS Tax Code 7702. The policy cannot be reversed after a policy has been reclassified as an MEC.
• Corridor Test HTML0 Corridor Test determines if a policy is underfunded. It is based on the Corridor, which refers to the amount that is different between the cash values of the insurance policy and the death benefits. If cash exceeds the Corridor, the policy will be classified as overfunded and considered an MEC.

What if My Life Insurance Policy Doesn’t Meet Tax Code 7702 Guidelines?

“While in theory, an indexed universal life (or other cash value) insurance policy could fail the CVAT or GPT, which would then cause it to lose the definition (and tax benefits) of life insurance, in practice life insurance companies will not allow this to happen,” Adams says. Adams.

Life insurance companies regularly check policies to ensure compliance with code 7702.

Life insurance companies usually conduct regular inspections of policies to ensure that they follow code 7702. If, for example, the policy fails the test it was designed to pass, the insurer will take the necessary steps to make it more compliant.

Adams offered two scenarios of what could occur if a life insurance policy does not meet tax code 7702 requirements:

• If a policyholder chooses to pass the Guideline Premium Test to keep their policy in compliance and then pay an amount of premium that would result in their policy failing the test, the insurance company will refund the premium to avoid the violation.
• If the client selects to take the Cash Value Accumulation Test when the cash value rises to the point where it violates this test, the firm will raise the death benefit amount to ensure that it conforms.

Tax Implications of Section 7702

If your plan is classified as an MEC due to its failure to meet the requirements of Section 7702, then you forfeit certain tax-free distribution benefits.

• Indrawals and loans. If you withdraw or obtain loans from an MEC, the amount you take is typically subject to taxation.
• Fines for distributions. If you withdraw funds from an MEC before reaching the age of 59 1/2, you may be liable to a 10% penalty for early withdrawals in addition to the tax on income.

Although code 7702 isn’t a life insurance policy, it’s a tax code. It’s also known as”a “7702 plan.” Non-compliance with code 7002 causes the reclassification of the life insurance plan into an MEC.

Pros of a 7702 Plan or MEC

While an MEC doesn’t have the same tax advantages as the cash value life insurance policy, there might be ways that an MEC could be incorporated into your financial planning. For example, the MEC could be an excellent option for those with specific estate planning goals. If your primary goal is to transfer wealth tax-free and not to enhance retirement, an MEC might be worth a look.

MECs could be the alternative to annuities regarding an estate’s planning. MECs are like deferred annuities, as they both are tax-deferred. However, MECs also benefit from a death tax-free; in contrast, annuities are tax-free upon your death. In addition, you might receive more interest on an MEC than indexed or deferred annuities.

Cons of a 7702 Plan or MEC

MECs don’t have the same tax benefits as the life insurance policy with cash values. The distributions are derived from the interest you earn on the cash value first. This means the cash you draw out of the policy will be treated as regular income.