What is a 702(j) Retirement Plan?

What is a 702(j) Retirement Plan?

A 702(j) account is frequently marketed as a retirement plan, but it’s actually a life insurance policy.

Sometimes referred to as a 702 or 7022 account, this type of plan is named after a section of the tax code.

Before you sign up for a 702(j), keep in mind that it is not an ordinary retirement account. A 702(j) is:

  • A life insurance policy
  • Set up to provide tax-free income in retirement
  • A plan that needs to be carefully monitored
  • A savings strategy with benefits geared toward those in the upper tax brackets

Here’s a look at how a 702(j) compares to other retirement plans and who might benefit from using this type of account.

How a 702(j) Works

Unlike other types of retirement accounts, a 702(j) is a permanent life insurance policy like whole life or universal life. To set up a 702(j), you first make a financial contract with an insurance company. You pay into the policy during a certain period of time. In addition to premiums, you can put in additional cash, which is referred to as overfunding. If certain guidelines are followed, you will be able to make withdrawals during your retirement years. The funds that you take out will not be subject to income tax. The policy might also provide a death benefit. “Overfunding is what creates the cash value,” says Mark Fried, president of TFG Wealth Management in Newtown, Pennsylvania. “The end game is to accumulate enough cash in the policy to pay the cost of the policy and generate a tax-free income in retirement for the retiree.”

How a 702(j) Compares to a 401(k) and IRA

A 401(k) is a retirement savings plan that is sponsored by employers. It allows workers to invest part of their paycheck before taxes are taken from it. This provides a tax deduction for employees and a way to invest consistently for retirement. Some companies will match an employee’s contribution to the 401(k), up to a certain limit. The money grows tax-free until it is withdrawn from the account. When you take funds out of a 401(k), the distributions are subject to taxes.

A traditional IRA is similar to a 401(k) plan, and the money deposited is also tax-deductible. The earnings in the account are not taxed each year. However, when you take out cash during retirement, you can expect the funds to be taxed as income.

Unlike a traditional 401(k) plan and a traditional IRA, a 702(j) doesn’t provide an initial tax break. “The investment into a life insurance contract is made with after-tax dollars, so there are upfront no tax deductions for investing your money,” says Bradford Creger, president of Total Financial Resource Group, Inc. in Glendale, California. If you follow the guidelines of the policy, you can withdraw money from the life insurance contract tax-free during retirement.

A 702(j) has several similarities to a Roth IRA. Like a 702(j), a Roth IRA doesn’t provide a tax deduction for money put into the account. During retirement, you can withdraw funds tax-free from a Roth IRA.

A 401(k), traditional IRA and Roth IRA all have limits regarding how much you can contribute each year. In 2019, the contribution limit for a 401(k) plan is $19,000, or $25,000 for those age 50 and older. For a traditional IRA and Roth IRA, the contribution limit is $6,000, or $7,000 if you are 50 or older. In contrast, a 702(j) does not have a contribution limit. “This amount is limited only by how much you can reasonably afford to invest,” Creger says.

When a 702(j) is a Good Fit

This type of plan tends to work best as a retirement strategy for individuals who have maxed out other investments, such as a 401(k). It can also be a good fit for those who are concerned about taxes during retirement. “As your income increases during retirement, so does your tax liability,” says Robert Chewning, managing director of wealth insurance services at Wells Fargo.

Individuals with an income of $250,000 or more may benefit most from a 702(j), due to the amount that can be contributed into the plan and the tax breaks it provides on withdrawals. “702(j)s work best with higher-income individuals,” Fried says. “If you’re not going to be in the upper tax brackets in retirement, it diminishes the value of a 702(j).”

What to Do Before Getting a 702(j)

This type of plan often comes with various fees and costs, so it’s important to ask questions upfront. “Before you get involved, you need to understand what you are doing,” says Mish Schneider, director of trading research and education at MarketGauge.com.

You’ll also want to look at your entire retirement strategy. “Plan first, and select investments second,” Fried says. You might want to look at what you’re currently putting into a 401(k) plan, what other investments you have, the amount of Social Security benefits to expect and any other pensions or retirement income.

Be aware that you’ll need to closely follow the 702(j) plan rules. When setting it up, “You have to work with someone who understands the rules, because otherwise you could end up losing that tax-free income benefit,” Fried says. “And request an in-force illustration every year.” This is a report from the insurance company that lays out what you have put into the plan, and if you are on track with the financial goals and estimates given when you first signed the contract.

Source: U.S. & World Report News
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