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Whats the difference between 7702 v 401K?

Which is better to invest in

Feb 05, 2013 by Alex from Hawthorne, CA  |  Flag
3 Answers   |  9 Followers
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8 votes
Jason Hull Level 20

Alex--I hate to tell you, but you're probably talking to a life insurance salesman who is trying to convince you to get into a life insurance product so that he can make a sackload of commissions. If your company has a match for the 401k, then it's going to be hard to beat the 100% ROI that you'll get on putting money into the 401k up to the point that the company match stops.

Ask the person who's trying to convince you that life insurance is an investing strategy to sign a fiduciary agreement (you can find one here: http://www.fi360.com/main/pdf/fiduciaryoath_individual.pdf ). Then see if the story changes a little. If I were a betting man, I'd place a fiver that this person is trying to get you into something like an indexed universal life or a variable universal life policy where he (the salesperson) is going to make a shedload in commissions off of you.

Furthermore, ask why you need an annuity at age 32. I'm a HUGE fan of single premium immediate annuities (see my U.S. News article about them here: http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2012/10/05/do-you-need-bonds-in-retirement ), otherwise known as SPIAs, but I'd be hard, hard, hard pressed to find a situation where they're right for a 32 year old, unless said 32 year old possessed somewhere in the range of a 9 digit net worth without including the decimal point.

I get that you're trying to find safe investments, and that, for you, return of capital, right now, is more important than return on capital. You don't want to lose your money because you probably felt the freefall in 2008.

One thing to look at is converting to a Roth 401k. You will pay tax now, but if you're going to stay in California or be in a higher tax bracket later, this might be a good option, since you won't pay tax later.

Regardless, the worst thing you can do at age 32 is stick your head in the sand and not invest. Inflation is a silent killer and will eat your spending power alive. It's awesome that you're investing and that you're putting money aside in a 401k. Don't let people fill you full of fear.

You can check out this article to read more about why you might be feeling a little gunshy now:

Article 1: http://www.hullfinancialplanning.com/why-past-performance-indicates-your-future-investing-actions/

Article 2: http://www.hullfinancialplanning.com/dont-watch-cnbc-before-talking-to-me-even-if-the-market-is-up/

Remeber, all of this is general information. You're probably well-served to spend a little time and invest in the services of a financial planner (you are, after all, on a site where they all hang out!). Make SURE that advisor has a fiduciary relationship with you (http://www.hullfinancialplanning.com/why-is-fiduciary-responsibility-paramount/ ) and isn't going to slaughter you with fees and commissions (http://www.hullfinancialplanning.com/the-cost-of-fees-in-your-investments/ ) while showing you a bunch of fancy charts (http://www.hullfinancialplanning.com/chart-porn-and-personal-finance/ ).

3 Comments   |  Flag   |  Feb 06, 2013 from Fort Worth, TX
Alex

Thank you kindly Mr. Hull. That was a great wealth of information. I will be sure to check out the links. Again, thank you much!

2 likes | 
Flag |  Feb 06, 2013 near Hawthorne, CA
Jason Hull

Glad to help! Sorry for the wonky links; the Brightscope team is working to correct them for me.

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Flag |  Feb 06, 2013 near Fort Worth, TX
Rod Miller, CFP®, CLU, ChFC

Mr Hull gives some great advice. Again, it all depends on your individual situation. But, if this information does not answer your question, please consult with a credible CFP or CPA. The wortst thing you can do is nothing at all.

3 likes | 
Flag |  Feb 06, 2013 near Springfield, MO

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5 votes

It all depends on your personal situation. A 401k most likely offers an employer "match" to what you contribute... for example, if, say, it's 50% of your contribution, which may vary depending on you individual plan... that's a 50% return on your investment even if the investment earns a zero percent rate of return. The 7702 plan you're asking about will have no employer match. You will be buying a life insurance contract instead, which also has some tax benefits as well. As such, again, without knowing your situation... would probably suggest you take the match first... when you max out the match and want to invest more, "might" consider the other option. Consult with a professional advisor or CPA before making the decision of "either/or". There are no "good" or "bad" products out there... they are only "tools" in our toolbox. If you need a phillips head screwdriver to remove a screw, a flat bladed one will not acheive your goal more than likely.

View all 4 Comments   |  Flag   |  Feb 05, 2013 from Springfield, MO
Michael Steven Greenberg, CFP®

Hi Alex. Please re-read Jasons first sentence. When you contribute to a 401k (or IRA) your money is before tax. When you take it out, you get taxed. Current Fed tax bracket on income (married filing jointly) for earners up to $146,400 is 25%. So if you were retirement age and withdrew (as your only income) up to $146,400, you would be in the 25% tax bracket, and even at that tax rates are marginal so the effective rate is less. Nowhere near 40%. At 32, you might want to consider future contributions into your Roth 401k account... it would be after tax dollars, and grow tax free just like a 7702. Your expenses would be tremendously lower. As for annuities, again please read Jasons first sentence. Fees can be over 4%, but I'm guessing your insurance guy wants to sell you a fixed annuity; the have either fees or caps on growth. Most annuities I know have a minimum issue age of 40. Perhaps because they might be inappropriate at younger ages. Read the fine print, or better yet, run away.

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Flag |  Feb 08, 2013 near Delray Beach, FL
Becca

Alex, not sure if you will check this comment. I learned7702 coz of my real estate agent. He said he's a financial planner for a company (don't wanna mention the compnay name). After a few meeting, I realized that he was selling life insurance. To me, he's more like a life ins agent, then a financial planner. I've no interest in buying universal life insurance at all. I'm from accounting background. When he tried to sell it to me, i know the plan didn't make sense. He didn't disclose any fees or anything. He enlarged the gain and benefit of the plan. Investment 101, never invest in something that you don't know / understand. Alex, always look @ cost vs. benefit. Fees can eat up your return. I was shocked that he tried to make me buy that plan when he knows i'm an accountant.

Flag |  May 28, 2013 near New York, NY

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2 votes

Alex, in my opinion, they really do not have anything in common, except some potential favorable tax treatment. 7702 is the section of the IRS Code that defines cash value life insurance. Period. There is no scheme for Congress to create a 7702 Plan. To be fair, cash value life insurance has some very favorable tax treatment, and some consider it the last great tax loophole.

First, there are a myriad of rules and tests as to whether it is considered life insurance or a modified endowment contract or ‘MEC’. You can typically only contribute ‘after tax’ premiums, you can only contribute a certain ratio of premiums to death benefit. If you have too much premium relative to death benefit, or if you contribute too quickly, you policy becomes a MEC, and then all distributions become taxable.

Your investment choices are limited to what is in the policy, and you cannot change policies as you can IRA accounts. You can get an ‘Indexed’ life insurance policy….beware there are always either caps on gains or fees.

I would also argue that your target premium might be impractical to maintain a death benefit and still build a large enough cash value to live off of in retirement.

Also if your policy ever lapses for any reason, all of your distributions become taxable. The IRS is effectively saying that if you have a life insurance policy with a cash value, you can borrow that cash as effectively an advance on your death benefit.

So let’s say you’re 60 years old, and build up a cash value of $200,000 on your $2,000,000 policy. You withdraw $100,000 to by that sailboat for retirement you always wanted. As you become 66 and 67 and 68and older, the mortality expense rises on your contract, and perhaps your investments don’t do so well. At some point, your policy runs out of cash value and expires. You have lost your death benefit, and you have a tax burden on that $100,000 distribution that you may have thought was tax-free. The logic for this cause and effect goes back to the premise that the tax advantage stems from this being life insurance; it was not intended for you to buy a boat, or house, or live off in retirement.

With that said, life insurance is one of the very few ways to get possible tax-free and penalty-free distributions. I think it is great if you have excess dollars, especially if you have a real need for life insurance. It can be fantastic as an emergency fund. I would argue you are only getting tax-deferred distributions, until you die with the policy in force; only then they become tax-free.

To be fair, 401(k) plans are not perfect. They have limits on contributions. There are penalties for early withdrawal. There are fees, but compare them to administrative and mortality expenses of life insurance. But when you leave employment you can transfer it to an IRA, where you have control of investments and fees. ERISA has rules to protect the participant and the plan’s integrity. They were designed, albeit with 73,000 pages of rules, to help and encourage you to save for retirement.

View all 4 Comments   |  Flag   |  Feb 08, 2013 from Delray Beach, FL
Scott

Nice answer. I agree with the 100% ROI argument for the 401k and debate if it is even ethical to call a life insurance policy or taking loans a tax free retirement. I also agree on your position with annuities, although I do think a 32 year old may have an argument to put 10-25% in an annuity. It all depends on the situation. Anyways, here is another article that might help more: http://finlit.biz/life-insurance/25-questions-you-should-ask-before-purchasing-a-permanent-life-insurance-policy/

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Flag |  Nov 26, 2013
Tunc Tanin

Michael, if you like the ROTH IRA's and then you would love cash value life insurance if you spent sometime analyzing it. A roth ira almost always outperfoms a VUL due to investment and insurance costs so you are correct in picking on the fees. However, you are limited to only 5000 a year for a 32 year old. You can contribute a lot more with a VUL. And for a 32 year old, you will probably have access to funds sooner if early retirement happens. With a Roth IRA only principal is available tax free until age 59.5. VUL would be available much sooner, it is a lot more flexible if funded over 20 years. For the VUL strategy to work it has to set up correctly and get funded regularly early on. The Roth IRA has a little more flexibility in the early years as you can fund in year 1 and skip year 2, the VUL is less forgiving if you skip in the early years.

Flag |  Oct 01, 2014 near Somerville, MA

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