Find out what Section 7702 defines as life insurance, how to determine whether a policy qualifies under its rules, and what it all means for you.
Section 7702 Definition
Qualified permanent life insurance policies receive valuable tax advantages, including tax-deferred cash value accumulation, tax-free loans and withdrawals, and tax-free death benefits. Section 7702 is the part of the IRC that defines what qualifies as a life insurance policy or contract for tax purposes using two tests: the cash value accumulation test (CVAT) and the guideline premium and corridor test (GPT). A policy needs to meet the requirements of either the CVAT or the GPT to comply with section 7702 and retain its tax advantages. If a policy no longer meets these requirements, it will be taxed as an investment at a higher rate. Insurers usually create life insurance policies in such a way that they’ll meet the requirements of one of the tests.
How Section 7702 Works
The tax advantages of permanent life insurance policies make them an attractive investment vehicle, but that’s not their intended purpose. Section 7702’s tests prevent investors from taking advantage of the life insurance tax loopholes. Here’s a deeper explanation of how these tests work.
The Cash Value Accumulation Test
For a policy to qualify under the CVAT, there must be a minimum gap between a life insurance policy’s cash surrender value and its death benefit. The cash surrender value must always be less than the net single premium necessary to fund the benefits of the contract. Here’s a closer look at what these terms mean. The cash value of a life insurance policy is a portion of the policy that works like a savings or investment account. If your account has a cash value, part of your premiums go to funding it, and the value can accrue interest and grow over time. The cash surrender value is the total cash value of the policy minus any surrender penalties, taxes, or fees you have to pay to cancel your policy. The net single premium is the amount you’d have to pay today to fund your policy’s future benefits. It’s equal to the present value of everything your contract will ever pay out. Putting that all together in an example, say you have a universal life insurance policy with a $750,000 death benefit and a $125,000 cash value. To pass the CVAT, the net single premium must be more than $125,000. If it’s less, the policy won’t pass the CVAT and therefore won’t qualify as life insurance under section 7702. Generally, CVAT policies let you contribute higher premiums sooner than GPT policies. Because CVAT requires a bigger gap between a policy’s cash value and death benefit than the GPT, this test is often used when a policyholder wants to maximize the death benefit. If the value of the policy reaches a certain amount relative to the face amount, a larger alternative death benefit may come into effect to ensure the policy continues to comply with the CVAT.
The Guideline Premium and Corridor Test
Unlike the CVAT, the GPT has two parts: guideline premium and cash value limitations. You have to clear both to pass the test. First, the GPT caps the premiums you can pay into the policy to the greater of either the guideline single premium (GSP) or the total of the guideline annual premiums (GAP) from when your policy was issued until the current date. The GSP is the premium you’d have to pay on the day the policy is issued to fund all its future benefits. It’s similar to the net single premium but uses a specific set of valuation assumptions. The GAP is the maximum you can pay into the policy each year over the life of the contract. It works on a cumulative basis, with any leftover room rolling over to the next year. For example, say your policy’s GAP is $6,000 per year. If you pay $5,000 in premiums in year one, you could pay $7,000 in year two. The second part of the GPT requires a minimum gap, known as the “corridor,” between the cash surrender value and the death benefit. It’s like the CVAT, but the minimum gap is smaller and changes based on the age of the insured person. For example, if the insured person is 40 years old or younger, their policy’s death benefit must be at least 250% of their policy’s cash surrender value. In other words, if the death benefit is $250,000, the cash surrender value has to be $100,000 or less. Tip: GPT policies focus more on lifetime cash value accumulation rather than maximizing the death benefit. If you intend to draw from your policy’s cash value during the insured’s life, a GPT policy is likely a better option than a CVAT policy.
The Bottom Line
Qualified life insurance policies have significant tax advantages, including tax-deferred cash value accumulation, tax-free loans and withdrawals, and tax-free death benefits. Section 7702 of the IRC defines two tests for determining what qualifies as a life insurance policy for tax purposes: the cash value accumulation test and the guideline premium and corridor test. A policy must pass one of them to keep its tax treatment. Insurers may let you decide which test you’d like your policy to meet, and the test is set once the policy is issued. CVAT policies are generally better for policyholders who prioritize the death benefit, and GPT policies are usually better if you care more about cash value, but consult with your insurance agent to determine which is best for your needs.
