702(j) Retirement Plans: Same as Life Insurance?
You may have seen sketchy sounding advertisements promoting a 702(j) retirement plan as a secret type of account the wealthy use.
Agreeably, 702(j) retirement plans sound an awful lot like other retirement plans including 401(k) plans or even Roth IRAs.
What may shock you is a 702(j) account isn’t a retirement plan at all. It’s not an investment vehicle.
You can’t open one at your brokerage firm. Instead, you have to buy it from a financial advisor or an insurance company.
If this sounds fishy, it’s because it is.
Here’s what you need to know about 702(j) retirement plans before you even consider signing up for one.
What Exactly Is a 702(j) Retirement Plan?
A 702(j) retirement plan is actually one of many types of insurance products you can buy.
In fact, it’s just one of the many types of life insurance contracts you can by. For most people, it probably isn’t even the best fit.
Other types of life insurance that you may be more familiar with include term life insurance and indexed universal life insurance.
The “702(j) retirement plan” is governed by section 7702 of the U.S. Code. It is a type of permanent life insurance. This insurance pays a death benefit assuming the policy is active at your death. It also may provide a cash value benefit.
Salespeople coined the term 702(j) to make it sound more like the 401(k) retirement plan. However, there is no reference calling these plans a 702(j) other than marketing.
The marketers took part of the U.S. Code, section 7702, cut it down by a number and added a letter to make it sound more like a retirement plan. Now that the term has been used for a while, it seems legitimate. In reality, it doesn’t really reference anything.
You should be extremely skeptical of any type of plan that uses this kind of marketing to get people to sign up.
How a 702(j) Account Really Works
As you’ve probably figured out, an actual 702(j) account doesn’t exist.
Instead, it’s simply a permanent life insurance policy governed by section 7702 of the U.S. Code. Here’s how these life insurance policies work.
Since a 702(j) is life insurance, that means the premium payments you make are allowed to grow tax-deferred.
The key that salespeople use to make you think this is a retirement plan is you can choose to pay additional premiums to help your cash value grow.
Later in life, as long as you follow the rules, you can take out a loan on the cash value of the policy without having to pay taxes on the money you borrow.
You could in theory use this money to fund your retirement, but it is a costly way to do so.
When you die, your beneficiary will generally receive a death benefit without having to pay taxes on it.
Why It Isn’t as Good as It Sounds
All of these benefits including tax-deferred growth, the ability to take out a tax-free loan and tax-free money to your beneficiary when you die sound amazing.
Unfortunately, marketers focus on these good parts of the policy. What they fail to mention are the not so good parts of the policy.
First, unlike investing in a legitimate tax vehicle like a 401(k), you don’t get a tax deduction for your life insurance premiums. That means the money put toward extra premiums to increase the cash value doesn’t impact which of the tax brackets you’ll fall into.
Next, permanent life insurance policies are normally very expensive. Life insurance companies want to turn a profit. Permanent life insurance means that the life insurance company is guaranteed to pay out the death benefit as long as you keep paying the premiums.
This means insurance companies have to make sure they can invest the money you pay in premiums to more than cover the death benefit they have to pay out and still make a profit. If they don’t, they could run out of money and go out of business.
They also have to pay for all of the marketing and the commissions to the agents that sell these policies.
These policies often pay the agents very high commissions. The high commissions may convince some agents to sell this product when it isn’t the best fit so they can get paid.
702(j) Life Insurance Policies May Still Have a Place
Just because this high cost life insurance policy isn’t a good fit for most people doesn’t mean it is bad for all people. There are certain cases where these insurance products may make sense.
Typically, these policies tend to fit high income or net worth individuals who are looking to for even more tax benefits after already maxing out their other options. Even so, high income or net worth individuals may be better off investing in a simple taxable investment account.
As always, consult a fiduciary financial planner that gets paid hourly when considering these types of plans.
These types of financial advisors should not accept commissions, so they technically should have no bias when it comes to telling you if they’re a good idea for your situation.
Financial advisors that make money on commissions, however, are financially incentivized to sell these plans.
Real Retirement Account Alternatives to 702(j) Accounts
If you want to have money saved for retirement that isn’t in a life insurance contract, you’re probably better off with traditional retirement plans.
Your workplace may offer a retirement plan such as a 401(k), 403(b), 457, TSP or another workplace retirement plan.
These retirement plans usually allow you to put away thousands of dollars pre-tax. That means you get a tax deduction for your contributions today, but have to pay taxes when you take the money out in retirement.
In particular, the 2019 limit for employee contributions to a 401(k) is $19,000 for those under age 50. Those 50 or older can contribute $25,000. Employers may also contribute additional funds on top of these amounts.
In 2020, the limit increases to $19,500 for employee contributions for those under age 50. For those 50 or older, the limit increases to $26,000.
These limitations are larger than the amounts most ordinary people set aside for retirement each year. As such, this could give you as much tax-advantaged retirement savings dollars as you need.
Some workplaces also offer Roth versions of these types of retirement accounts. The Roth version allows you to put money into the account after you pay taxes on it today. You don’t get a tax deduction now. However, you do get to withdraw the money tax-free in retirement.
You can use these accounts strategically if you believe the tax rate you’re paying now is lower than the tax rate you’ll pay in retirement.
If you don’t have a workplace retirement account, you may be able to open up an IRA. You can open an IRA through a brokerage firm and contribute up to the annual limit each year as long as you have earned income to do so and you meet any other requirements.
For 2019, the contribution limits to an IRA is $6,000 for those under age 50. If you’re over age 50, the limit increases to $7,000. For 2020, these limits remain the same unlike with 401(k) plans.
When you invest in these types of plans, it is possible you could lose money. However, the fees normally are much more reasonable than you’d pay with a permanent life insurance policy.
Other Options to Provide Retirement Income
You don’t have to save in a retirement account to have money for retirement. If you’ve maxed out your retirement account possibilities, you can open a taxable investment account to invest even more money.
You won’t get tax breaks on a taxable investment account as you would with a retirement account. Even so, you may qualify for lower capital gains tax rates if you hold certain investments for the proper time periods.
Traditional stock, bond and mutual fund investments aren’t your only option, either. You could invest in rental properties that generate cash flow. Once you pay off the mortgage, the monthly rent payments could be your retirement income.
Another option is starting a business. You could build your business to pay yourself a steady income in retirement even after you quit working within the business. Alternatively, you could sell the company to generate a substantial nest egg.
Research and Decide for Yourself
As always, it makes sense to get all of the information and compare the options for yourself. It could be that your situation is one of the cases where a 702(j) life insurance policy makes sense.
If you need help making a decision, consult a fiduciary financial advisor. Remember to seek out one that gets paid on an hourly basis, not one that is compensated by commissions.