What Is Section 7702?

Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code defines what the federal government considers to be a legitimate life insurance contract and determines how the proceeds ge⛦nerated by the policﷺy are taxed.

The proceeds of policies that do not meet the government's definition are taxable as ordinary income. Proceeds from genuine life insurance contracts are 澳洲幸运5官方开奖结果体彩网:tax-advantaged. Section 7702 applies only to life insurance contracts issued after the year 1984.

Understanding Section 7702

Prior to the adoption of Section 7702, federal tax law took a fairly hands-off approach when it came to the taxation of life insurance policies. The government did not want to be seen taxing needy widows and children, so 澳洲幸运5官方开奖结果体彩网:death benefits paid to life insurance beneficiaries became exempt from 澳洲幸运5官方开奖结果体彩网:income tax. Any gains that accrued within the policy during the policyholdeꦯr's lifetiℱme were not taxed as income.

While this favorable tax treatment may look reasonable on the surface, problems arise when the system can be rigged, such as when other types of 澳洲幸运5官方开奖结果体彩网:investment accounts are passed off as life insurance products.

To prevent this from happening, Section 7702 created a list of requirements used to ensure that only genuine life insurance policies received advantageous tax treatment and not investment vehicles masquerading as them.

Requirements of Section 7702

To qualify as a legitimate life insurance policy under Section 7702, contracts must pass one of two tests: the cash value accumulation test (CVAT) or the 澳洲幸运5官方开奖结果体彩网:guideline premium and cor𓆏ridor test (GPT).

Cash Value Accumulation Test

The cash value accumulation test stipulates that the 澳洲幸运5官方开奖结果体彩网:cash surrender value of the contract "may not at any time exceed the net single premium which would have to be paid at such time to fund future benefits under the contract."

That means that the amount of money a policyholder could get out of the policy if they were to cancel it (often referred to as the savings component of 澳洲幸运5官方开奖结果体彩网:cash value life insurance) can't be greater 🧸than the amount that the policyholder would have paid to purchase the policy with a single lump sum, not including any fees.

Guideline Premium and Corridor Test

The guideline premium and corridor test requires that "the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitation as of such time." This means that the policyholder can't have paid more into the policy than would be necessary to fund its insurance benefits.

If a life insurance policy fails to pass either of those tests, Section 7702(g) stipulates that the income on the contract will be treated as 澳洲幸运5官方开奖结果体彩网:ordinary income for that year and taxed accordingly. In other words, the owner of the contract will lose the favorable tax treatment of a true life insurance policy.

The Bottom Line

Section 7702 plays a crucial role in determining how permanent life insurance policies, such as whole life and universal life, are treated for tax purpo⛦ses. To maintain tax advantages, these policies must meet specific IRS criteria, including the cash value and premium limitations. Policies that fail these tests are classified as modified endowment contracts (MECs) and lose their tax-advantaged status. Understanding Section 7702 is essential for both policyholders and financial professionals to ensure compliance and avoid unintended tax consequences.