A 702(j) retirement plan really isn’t a “retirement plan” at all. It’s a cash value life insurance policy sold as a retirement plan. You may have heard the spiel. The promise of a 702(j) plan is tax-free retirement income. It is possible to access the cash value in a life insurance policy tax-free, but there are a lot of drawbacks.
I’ll explain the basic tenets of 702(j) retirement plans in this article.
What is a 702(j) Retirement Plan?
A 702(j) retirement plan is a life insurance policy sold for the purpose of accumulating cash value that you can access tax-free in retirement. Because it is a life insurance contract you’ll pay premiums to own it. A portion of the premium goes to funding the cash balance. The rest of the premium will cover the cost of the insurance and various expenses.
The cash balance also earns interest, so it grows over time. The typical arrangement in a 702(j) plan is to contribute more than the minimum premium to the policy so the cash balance grows even more.
Then you can withdraw that cash balance in retirement, partially tax-free. If you withdraw it outright you would have to pay taxes on the amount that is over the premiums you paid. This “tax-free return of basis” is the typical tax arrangement anytime you buy or invest something.
If you borrow the cash balance from your 702(j) plan you won’t have to pay taxes on it, but you’ll have to pay the money back just like any other loan. This is usually the preferred method of accessing the cash since it is entirely tax-free.
Withdrawals are treated as first-in, first out. That means that since your premiums went into the cash value before growth did, your withdrawals are tax-free up to the amount of premiums paid in.
What are the Drawbacks of 702(j) Retirement Plans?
There are some instances when a 702(j) plan might make sense, but not many. For most people, you can manage your taxes and retirement income plan in much simpler and more effective ways. Actual retirement plans like 401ks, 403bs, and IRAs are much better conduits for retirement savings. Even if you max these out, simply having a tax-aware investment strategy for your taxable accounts is often a better choice with a lower potential for a major screw-up.
The Premium Isn’t Deductible
If you are using a life insurance contract as a retirement plan then it makes sense to compare the premium to retirement savings. That being the case, you don’t get a tax-break for paying an insurance premium. If you saved the money instead in a 401k or IRA you’d be able to deduct it.
Since 702(j) plans are whole life insurance contracts they have all the associated expenses. If you need insurance, buy insurance. If you want to save for retirement, save for retirement. These are two different things that are rarely better when combined.
Easy to Mess Up
There are a lot of things that can go wrong with a 702(j) retirement plan. These mistakes can create the tax complications you were attempting to avoid by creating the plan in the first place.
Remember that you can access the cash balance tax-free by taking out a loan. However, if you let the policy lapse while you have the loan it becomes taxable as a distribution. Letting the policy lapse is easier than it sounds. For example, simply taking out the entire cash balance would cause the policy to lapse.
Because one of the key features of a 702(j) retirement plan is to over-fund the cash balance, you run the risk of creating a modified endowment contract, or MEC. MECs come with their own set of tax consequences like early withdrawal penalties and taxable distributions. The worst part is you can’t reset a MEC. Once you cross the line there is no going back.
702(j) Retirement Plan Alternatives
If you aren’t taking complete advantage of tax-advantaged retirement accounts then start there. If you are maxing out your retirement plan at work and your IRA, then consider tax management strategies as well.
Mega backdoor Roth conversions can be a good strategy for creating tax-free retirement income, but you need to plan ahead and think about where the cash to pay the conversion tax will come from.
Don’t neglect taxable investment accounts either. Long-term capital gains and a good asset location plan can go a long way to reducing your retirement tax bill without the hassle and liability.