Section 7702

What Is Section 7702?

Section 7702 of the U.S. Internal Revenue Service (IRS) Tax Code defines what the federal government considers to be a legitimate life insurance contract and is used to determine how the proceeds the policy generates are taxed.

The proceeds of policies that do not meet the government's definition are taxable as ordinary income. Proceeds from genuine life insurance contracts are tax-advantaged. Section 7702 applies only to life insurance contracts issued after the year 1984.

Key Takeaways:

  • Section 7702 of the Tax Code differentiates between income from a genuine insurance product and income from an investment vehicle.
  • Certain types of permanent life insurance build up a cash value over time.
  • The proceeds of a true life insurance contract receive favorable tax treatment.
  • The proceeds of a contract that does not meet the IRS definition are taxed as ordinary income.
  • An insurance policy that fails Section 7702 criteria becomes a modified endowment contract (MEC) and permanently loses its tax-advantaged status.

Understanding Section 7702

Prior to the adoption of Section 7702, federal tax law took a fairly hands-off approach when it came to the taxation of life insurance policies. Death benefits paid to life insurance beneficiaries were exempt from income tax, and any gains that accrued within the policy during the policyholder's lifetime were not taxed as income.

While this favorable tax treatment may look reasonable on its surface—the government did not want to be seen taxing needy widows and children—problems arise when the system can be rigged, such as when other types of investment accounts are passed off as life insurance products.

To prevent this from happening, Section 7702 created a list of requirements used to ensure that only genuine life insurance policies received advantageous tax treatment and not investment vehicles masquerading as them.

 
 Source: Investopedia