702(j) retirement plan: What is a 7702 retirement account?

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Most people hate to pay taxes. That's not hard to understand. What is baffling is the lengths people will go to avoid taxes – sometimes, the cost of avoiding taxes exceeds the taxes themselves.

The reason this happens is that for some people, all they have to hear is that a scheme will help them avoid taxes, and they are on board. Remember though, avoiding taxes should not be your ultimate goal. The idea is to earn the best after-tax return. That means avoiding taxes is only worthwhile if the cost and risk involved don't diminish your investment return too much.

In Focus: 702(j) Retirement Programs

These are important issues to examine if you are considering a 702(j) retirement account.

What is a 702(j) retirement account? It is commonly pitched as a way to accumulate retirement income tax-free. The real story, though, is more complicated than that.

What is a 702(j) retirement account?

The 702(j) is the popular shorted name of Section 7702, a portion of the US tax code which pertains to life insurance policies. At heart, that's what these 702(j) retirement schemes are – life insurance policies which accumulate cash value.

Since life insurance benefits are free from income taxes, they can be a way to accumulate savings without paying taxes. Some policies allow you to access a portion of your accumulated benefit prior to death, which is how they can act as a source of retirement income.

Sounds straightforward enough, but there's a catch. Actually, several catches.

Here's the catch….

A life insurance policy can be a valid method of wealth accumulation, but how effective this is depends on the details. And there are a lot of details. Here are some of the things to understand before committing to a 702(j) retirement program:

Premiums are not deductible

The tax-advantaged angle is simply that benefits accumulate and are paid out tax-free, but unlike contributions to a 401k plan or a traditional IRA, the premiums you pay into a life insurance policy are not deductible. This makes the tax characteristics of a 702(j) retirement program more similar to those of a Roth IRA, for which contributions are not deductible but investment earnings are not taxed.

It's a long-term commitment

If you run into financial difficulties at some point, you may have to stop paying premiums. Depending on the terms of the policy this could substantially reduce or negate the benefits you accrue. In order for a 702(j) plan to deliver the advertised retirement benefits, you have to be able to commit to making the premium payments on schedule.

The extra retirement income isn't really income

Any retirement income produced by a 702(j) program will reduce the ultimate benefit paid by the insurance policy, since it typically represents a loan or advance against the ultimate death benefit.

Accessing that money may be costly

Borrowing against the death benefit is likely to entail an interest cost, which would reduce the ultimate benefit by more than you take out for retirement income.

Interest rate risk is especially acute right now

The relationship between the premiums and benefit of the insurance policy would be based on current interest rates, which are very low. This means benefits would accrue at a slow pace. However, if you borrow against that benefit several years in the future, the interest rate by then may well be much higher. This means that the money you borrow could cost you interest at a higher rate than the pace at which benefits are accruing.

The long-term return is murky

If that last point left you scratching your head, get used to the confusion. Assessing the benefit of a 702(j) retirement account depends on being able to figure out the rate of return implied by the relationship between the benefits and the premiums, and the length of time over which both are paid. Until you can figure that out, you don't really know if a given policy is better than conservative vehicles such as CDs or savings accounts, let alone long-term investments like stocks and bonds. In other words, you can't make a blanket judgement about whether 702(j) programs are good or bad – the answer depends on the specific terms of the insurance policy.

There is a stroke-of-the-pen risk

The tax-free status of payments out of a 702(j) retirement account depends on a bit of a tap dance. Benefits from life insurance policies are not taxable. By borrowing against those future benefits, the policyholder can get that tax advantage without having to actually die. This is precisely the type of loophole that tax reforms often target, so there is the risk that with the signing of a new tax law in the future, the retirement savings aspect of these policies may become invalidated.

There is also counterparty risk

When you have a bank account, your money is guaranteed by the FDIC. When you have a retirement investment account like a 401(k) or an IRA, there are specific assets held for your benefit. In contrast, an insurance policy represents a general obligation of the insurance company, so your benefits are only as secure as that insurance company. To be sure, there are strict rules governing how insurance companies fund their obligations, but as the last financial crisis demonstrated, these safety measures don't always hold up under pressure. Counterparty risk means that the arrangement is only as good as the party on the other side of the deal, in this case, the insurance company. When you are contracting for benefits to be paid decades in the future, there is a lot of time for counter-party risk to become an issue.

Does a 702(j) make sense for your retirement income plan?

702(j) retirement accounts don't appear to offer superior tax characteristics to more traditional retirement programs, such as a 401k plan or an IRA. A 702(j) program might be a viable option if you are already maxing out your allowable contributions to those retirement programs and want to amass some savings over and above that.

Even then, don't sign up for an insurance policy until you have crunched the numbers and figured out that its benefits are likely to offer you a better after-tax return on the premiums you pay than you would earn for CD rates or long-term investments. And, if you find the terms too complicated to understand, then walk away. Financial salespeople often like you to feel that there is a mystery to complicated programs that makes them work. Usually though, in the end the only mystery in such cases is where your money went.

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