What Is Section 7702?
Section 7702 of the U.S. Internal Profits Provider (IRS) Tax Code defines what the federal government considers to be a valid life insurance policy contract and is used to get to the bottom of how the proceeds the protection generates are taxed.
The proceeds of insurance coverage insurance policies that do not meet the government’s definition are taxable as peculiar income. Proceeds from unique life insurance policy contracts are tax-advantaged. Section 7702 applies absolute best to life insurance policy contracts issued after the year 1984.
Key Takeaways
- Section 7702 of the Tax Code differentiates between income from an actual insurance policy product and income from an investment automotive.
- Positive varieties of permanent life insurance policy building up a cash value over time.
- The proceeds of an actual life insurance policy contract download favorable tax treatment.
- The proceeds of a contract that does not meet the IRS definition are taxed as peculiar income.
- An insurance policy that fails Section 7702 requirements turns right into a modified endowment contract (MEC) and fully loses its tax-advantaged status.
Understanding Section 7702
Prior to the adoption of Section 7702, federal tax regulation took a quite hands-off approach when it were given right here to the taxation of life insurance policy insurance coverage insurance policies. Death benefits paid to life insurance policy beneficiaries have been exempt from income tax, and any options that accumulated within the protection right through the policyholder’s lifetime were not taxed as income.
While this favorable tax treatment would perhaps look inexpensive on its flooring—the government did not need to be spotted taxing needy widows and children—problems get up when the device will also be rigged, similar to when other varieties of investment accounts are passed off as life insurance policy products.
To prevent this from happening, Section 7702 created a list of requirements used to make certain that absolute best unique life insurance policy insurance coverage insurance policies won great tax treatment and now not investment cars masquerading as them.
Prerequisites of Section 7702
Life insurance policy contracts should move one in all two checks: the cash value accumulation test (CVAT) or the guideline of thumb most sensible fee and corridor test (GPT).
Cash Worth Accumulation Test
The cash value accumulation test stipulates that the cash surrender value of the contract “would possibly not at any time exceed the internet single most sensible fee which would possibly wish to be paid at such time to fund long term benefits under the contract.
That implies that the amount of money a policyholder would possibly get out of the protection within the tournament that that they had been to cancel it (without end referred to as the “monetary financial savings” part of cash value life insurance policy) can’t be greater than the volume that the policyholder would have paid to shop for the protection with a single lump sum, now not in conjunction with any fees.
Guideline Most sensible fee and Corridor Test
The guideline of thumb most sensible fee and corridor test requires that “the sum of the premiums paid under such contract does now not at any time exceed the guideline of thumb most sensible fee limitation as of such time.” Which means that that the policyholder can not have paid further into the protection than may well be essential to fund its insurance policy benefits.
If a life insurance policy fails to move either one of those checks, Section 7702(g) stipulates that the income on the contract could be treated as peculiar income for that year and taxed accordingly. In numerous words, the owner of the contract will lose the favorable tax treatment of an actual life insurance policy.
Why Are Permanent Life Insurance policy Contracts Given Favorable Tax Treatment?
Life insurance policy contracts are intended via design to offer a cash get advantages to a minimum of one’s beneficiaries after they move away. While the insured is still alive, permanent life insurance policy contracts like complete or commonplace life can achieve a cash value that can be withdrawn or borrowed in opposition to. Alternatively, because of the ones contracts are regarded as as insurance policy, and now not as an investment, they are granted certain tax benefits. A protection loan, as an example, is won tax-free.
What Is a Modified Endowment Contract (MEC)?
A modified endowment contract (MEC) is a long lasting life insurance policy that fails the Section 7702 requirements because of it is been “overfunded” with a substantial amount of cash value relative to the size of its lack of lifestyles get advantages, as defined via IRC Section 7702a. Rules set out throughout the Technical and Miscellaneous Profits Act of 1988 (TAMRA) specify a seven-pay test, in which premiums paid into the protection cannot exceed all of the amount that will likely be needed to have the protection utterly paid up within seven years. If an insurance policy turns right into a MEC, it loses its tax advantages and cannot revert once more to a non-MEC status.
When Was Section 7702 of the Tax Code Written?
Section 7702 and all similar subsections have been enacted in 1984.
