Whether you had an insurance salesman aggressively pitch you a 702(j) retirement plan or you read information about it online, the question still remains – “what is it?”
First, a 702(j) plan is not a retirement plan at all – it’s a life insurance contract. That’s right, a 702(j) is not a retirement plan, even though that is how it is marketed.
The name comes from Section 7702 in the Internal Revenue Code, which regulates life insurance contracts. Most people are familiar with at least one of these retirement plans – 401(k)’s, 457, IRA 403(b), TSP – and the companies that market 702(j) plans want you to view it in the same light. It is important to understand the distinction. I encourage you to visit the IRS website to view all the retirement plan options if want more information about what is included.
Understanding life insurance
A permanent life insurance policy combines a death benefit with a savings portion. As you pay your premiums, over time you begin to accumulate a cash value component that you can borrow against. The growth of the cash value is tax-deferred, meaning you do not pay taxes. You are also able to take money out of your cash value as a tax-free loan.
The thought is that you can overfund your insurance policy – pay more than the required premium – and then have the ability pull money out of your cash value as a tax-free loan during retirement.
It’s important to be careful how much you take out because if you do not pay back the loan before you die, the death benefit is reduced by the amount of the outstanding loan plus interest.
In another more troubling scenario – if you take a loan out of your policy that is equal to the cash value, the insurance company will force the policy to lapse and you will be hit with a large tax bill.
Taking a deeper dive into 702(j)
Chances are the 702(j) account is going to be a variable or indexed universal life policy. The insurance company will hand you a stack of paper full of legal, mind-numbing language that will include a policy illustration that highlights very rosy return assumptions. The product is also advertised as having no risk because it will not decrease in value, even if the stock market loses money.
Let’s pause here to ask the question – is this too good to be true?
The answer generally is yes. When the index the policy is tracking is performing well, the insurance company caps the amount that is credited to your account. When the index the policy tracking is down, you may not have any money credited to your account.
The fees on these products are typically outrageously high and are skewed to the benefit of the insurance company and insurance salesman. There are administrative fees, mortality charges, surrender charges, and a large upfront commission that is paid to the insurance salesman.
It is very difficult to determine the total amount you’re paying in fees because of the way they are presented. In other words, they are not fully transparent and disclosed.
Fees are extremely important to take into consideration when evaluating options for retirement because the effects are compounded over a long-time horizon. In other words, high fees and costs can cause serious harm to your retirement savings.
Evaluate the alternatives
Most fiduciaries – individuals that are required to act your best interest – including myself, believe you should fully fund other retirement vehicles first, such as a 401(k), 403(b), IRA, or Roth IRA.
There is generally more flexibility in your investment options, lower fees, and more transparency.
The bottom line
Make sure you receive investment advice from someone who is a fiduciary. If the person you are speaking with does not have to act in your best interest, how can you be sure they are giving you straight-forward advice? Before you consider any investment idea, make sure the person’s motives are aligned with yours.
Understand what you are investing in, the fees, and other alternatives.
If something sounds too good to be true, it generally is.