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What's a 702(j) retirement plan? Should you get one?

A 702(j) plan is not actually a retirement plan at all; it's a life insurance contract. But the idea of using it to supplement retirement income isn't new. 

In recent months, insurance salesmen have been marketing 702(j) plans as a new kind of retirement plan. This has聽sparked plenty of consumer questions about whether these plans are an investment vehicle worth pursuing. Here鈥檚 a closer look at what these plans are 鈥� and are not.

First, a 702(j) plan is聽聽鈥� it鈥檚 a life insurance contract. It鈥檚 defined under聽聽(hence the name), which states that for a financial product to qualify as a life insurance contract, it must pass one of two tests:

• The cash value accumulation test聽makes sure that the cash value of the insurance policy 鈥� all of the money that you鈥檝e paid, plus earnings 鈥� does not exceed the present value of all future payments on the policy. (鈥淧resent value鈥� is what an amount of money in the future is worth in today鈥檚 dollars, factoring in the expected rate of return.)
• The guideline premium test聽limits the amount of money that can be paid into an insurance policy relative to the corresponding death benefit.

If it passes one of these tests, the financial product can be taxed as life insurance rather than as an investment. That means the monthly premiums you pay can grow tax-deferred and be accessed tax-free via policy loans. It also means the beneficiary can receive the death benefit free of income taxes.

The idea is that you put more than the minimum required premium payment under the two聽tests into a cash-value life insurance policy 鈥� universal life, whole life or variable universal life 鈥� during your savings years. Later on, you can withdraw money from the policy via a tax-free loan to pay for your retirement, buy a car, put kids through college or whatever you want. This can be another income option in retirement, to go along with Social Security, pensions and investments.

If you go this route, it鈥檚 generally a good idea to make contributions for at least eight to 10 years before you take any money out, because this will provide more time for your policy to grow and your earnings to compound.

The idea of using a life insurance contract or a 鈥�702(j) retirement plan鈥� to supplement retirement income isn鈥檛 new. People have been using permanent life insurance for decades, and the popular sales pitch is that wealthy people have been doing this for a long time聽鈥� implying that the rest of us should as well.

The life insurance sales industry has long had catchy slogans for聽this kind of product, like 鈥淏ank on Yourself,鈥� 鈥淏e Your Own Bank,鈥� 鈥淚nfinite Banking鈥� and others.

Like buying an expensive car

Should you get one? Well, that depends. First, you need to recognize that life insurance has fees associated with it. You have to pay for the cost of the insurance, mortality and expense charges, administration charges, annual policy fees, state taxes and the marketing expenses (commissions) that go to whomever is telling you about the plan.

Second, make sure you can fund the policy properly. Setting up one of these plans is like purchasing an expensive car 鈥� you get lots of benefits, but your maintenance costs, insurance, gas, etc., add up, and you need to take care of your purchase. The Internet is full of dissatisfied 702(j) purchasers who rue the day they started the plan, just like people who bought expensive cars and found they couldn鈥檛 keep up with the maintenance.

So does it make sense to聽trade the fees on the insurance policy for the taxes to the IRS?

The only way to find out is聽by doing a complete analysis of your financial situation and calculating what your tax burden is. Generally, it makes mathematical sense for people聽to fully fund their聽,听听补苍诲听聽before they purchase any 702(j) plan or look at using life insurance to supplement their retirement income.

If you鈥檙e doing all of these things and you still have disposable income that you want to save for the future, a properly constructed 702(j) plan may make sense. High wage earners who expect to have high incomes in retirement聽might find it an especially good fit. That鈥檚 because life insurance contracts don鈥檛 count as income in retirement.

They don鈥檛 count toward the provisional income test to determine how much of your Social Security is taxable in retirement (up to 85% can be taxable). They don鈥檛 count toward the Medicare Part B premium penalty surcharges.

Most importantly, they don鈥檛 have required minimum distributions, in contrast to IRAs and 401(k) plans that require you to take distributions at age 70陆 whether you need the money or not. Required minimum distributions聽are taxed as ordinary income, and for many retirees this causes a domino effect and bumps them up into unnecessary Social Security taxation and Medicare Part B premium penalties.

This can all be avoided by having tax diversification in retirement, and a properly funded life insurance contract can provide聽that.

Tax implications are key

If I鈥檓 talking with clients about whether this type of product is suitable, I look for ways that we can properly manage their existing deductions and tax brackets first, and put as much money as possible into their qualified plans. When it鈥檚 time for them to retire, we strategically convert these taxable retirement accounts to tax-free Roth accounts and reduce their income tax obligations via smart tax-bracket planning, strategies for claiming聽Social Security benefits, and the proper use of charitable remainder trusts and tax-deduction techniques.

If we decide to go with a 702(j) plan, I generally recommend a commission-free, low-cost, variable universal life policy as the funding vehicle, instead of the more expensive whole life and indexed universal life alternatives. It pays to consult聽with a professional who knows how all of them聽work. Seek out someone who can compare and contrast the different policies before you commit to anything. This is your money and your life, and you want to make the right choice.

Over time, the ability to receive a tax deduction on your IRA and 401(k) contributions, convert to a Roth account at a lower rate via tax-deduction vehicles and have a properly funded insurance plan in retirement can give you聽the ultimate in tax savings and diversification.

, CFP, is a fee-only financial advisor聽who helps clients build, manage and preserve wealth, choose an insurance plan and develop a plan for retirement.Learn more about Dave聽on NerdWallet鈥檚聽.

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