By Dr. James M. Dahle, WCI Founder
I was really mad the first time I wrote this post. It was full of zingers and attacks against specific insurance companies and specific insurance agents who have been taking advantage of doctors using the terms TFRA and 7702 Plan. My staff convinced me to take them all out because they were too personal and because there were libel liability concerns (even though everything I said was 100% true). I hope the post is still worth reading. Let's just say this instead:
If you are using the words “TFRA” or “7702 Plan” to sell cash value life insurance to doctors, I think you're a dirtbag.
I feel like I've written about the schemes of insurance salespeople ad nauseam over the years. However, it seems I have to keep writing about it because the same old lies about it keep being told over and over again. Just today, we got two more emails about different ways salespeople are trying to sucker doctors into buying cash value life insurance policies they don't need and, once they understand how they work, don't even want. Here are the latest examples:
“I'm reaching out to get your take on IRC 7702 “plans.” The reason I ask is because I don't think I've heard them mentioned on your site or daily mailings before and, if I'm reading correctly, it sounds like a cash-value life insurance policy. I know you've said that we shouldn't mix investing with insurance policies, but I just want to be sure I'm understanding this correctly. The same tax company I mentioned before that said a Backdoor Roth may not be in my best interest, is now offering this 7702 plan to me as a way to possibly decrease my overall tax burden. I'm not sure this is the best way to do it, though.”
“Are there any blog posts or info on TFRAs? I recently saw an advertisement on this and was interested as another form of retirement savings.”
Let's get into it.
What Is a 7702 Plan?
What exactly is a “7702 Plan”? No, it's not some complicated insurance scheme. Section 7702 of the Internal Revenue Code is simply that section that explains the basic requirements that a life insurance policy has to meet to not be a Modified Endowment Contract (MEC). A MEC does not qualify for the usual tax benefits of life insurance (like being able to do tax-free partial surrenders up to basis and to borrow tax-free against the policy.) A MEC does still provide a tax-free death benefit. That's it.
A 7702 plan is just a cash value life insurance policy, like whole life, variable life, or any of the types of universal life policies (such as the agents' current favorite, index universal life (IUL)).
Take a look a section 7702. Here's what it says:
26 U.S. Code § 7702 — Life Insurance Contract Defined
For purposes of this title, the term “life insurance contract” means any contract which is a life insurance contract under the applicable law, but only if such contract-
(1) meets the cash value accumulation test of subsection (b), or
(2) (A) meets the guideline premium requirements of subsection (c), and
(B) falls within the cash value corridor of subsection (d).
That's it. Pretty much every cash value life insurance policy being sold out there is a “7702 Plan.” So when an agent comes touting one of these to you, just recognize it for what it is. If you wouldn't buy it because they call it a “whole life insurance policy,” then don't buy it because they call it a “7702 Plan.” It's the same thing.
TFRA Retirement Account
TFRA, according to the agents selling life insurance using this term, stands for Tax Free Retirement Account. Obviously, it's not an account. It's an insurance policy. Be sure to not confuse it with the Canadian equivalent of a Roth IRA, known as a TFSA or Tax Free Savings Account. It's not some new thing. It's not something “most financial advisors don't know about.” It's just a new name for the same old thing they've been hawking for decades to young doctors who owe $300,000 in 7% student loans. You can't make this stuff up.
If you find a website selling this, you often find a very pretty (and, to the financially illiterate, a very attractive) package. But that's all it is: a package. They're just dressing up cash value life insurance policies to look like something else. This is the part of the post where I deleted nine screenshots I had taken from an actual website by an agent trying to sell Index Universal Life insurance policies to people as a “TFRA.” Instead of posting the screenshots, I'll just vaguely refer to what they said.
Confusing the Reader
The first thing the site does is confuse you about what tax-free retirement accounts really are. If you're financially literate, you know what they are. They typically start with the word “Roth.” We're talking about Roth IRAs, Roth 401(k)s, Roth 403(b)s, and Roth 457(b)s. Once the money is in the account, it grows tax-free, and withdrawals for retirement purposes are tax-free. That's a tax-free account. A tax-free account is NOT an insurance policy. It is certainly not an insurance policy that only allows you to borrow against your cash value. If you have a cash value life insurance policy and you surrender it to get all of your cash value out, you will not only pay taxes on all of the gains, but you will pay ordinary income tax rates on all of your gains. That's not a tax-free retirement account, no matter what an insurance agent puts on their website. Let's keep going.
The next screenshot showed a section of the site telling you that your financial advisor is not going to tell you about TFRAs. This agent is going to let you in on a secret that your financial advisor has been keeping from you. In fact, your advisor apparently DOESN'T EVEN KNOW about cash value life insurance and even if they did, they couldn't help you get any. While he has a good point that there are a lot of brokers and mutual fund salespeople out there masquerading as financial advisors, a real financial advisor certainly knows about these “TFRAs.” They also know they're not a good idea for almost anyone. My favorite part of this marketing schpiel is that the agent added “taxable” to the front of 401(k) to further emphasize how awesome this “TFRA” is. Never mind that the 401(k) contribution provided a huge tax deduction and that there was no deduction for money put into this “TFRA.” We'll just ignore that little inconvenient fact.
The next screenshot I had included was more marketing copy disguised as biographical information about the agent. The agent sounds so wonderful. He wants to help his clients. He has “new and exciting” strategies. He walked away from a “robust package” just to be better for you. He puts your interests first. He has access that other people don't. My favorite part is that “the vast majority of my clients have never seen [these strategies] before we started working together.” You know why? Because those who HAVE SEEN these strategies would never work with this guy.
When I went to BrokerCheck, I discovered the agent has been selling insurance for seven years and had only been in business for himself for one. Previously, he worked for three different companies that compose a who's who of insurance companies to avoid if you're a doctor. I won't mention them by name, but if you've been around this space for long, you know who they are. The first one might rhyme with Schporthpestern Tutual. The first two are companies that sold me inappropriate life insurance policies for my needs. Needless to say, none of these companies would ever show up on the WCI recommended financial advisor or insurance agent list.
The Arguments for a TFRA
OK, let's get into the only actual arguments on the website and point out all the half-truths. The next screenshot (again deleted prior to publication) was from a section of the website where the agent compared traditional (i.e. real) retirement accounts with his TFRA. First, we'll start with what he says about the problems with retirement accounts.
#1 You have to pay taxes.
Yup, you have to pay taxes before you put money into a Roth IRA. Oh wait, you have to do that before putting it into a “TFRA” too. Half-truth.
#2 Your money is not liquid.
Yes, it is. Remember you can take the principal out of your Roth IRA tax-free and penalty-free any time you want. Earnings come out tax-free, too, but you would have to pay the 10% penalty if you're under 59 1/2 and don't qualify for an exception (many do). With a tax-deferred account, you would have to pay the taxes (remember that tax deduction you got?) and penalty if you don't qualify for an exception. But to say it isn't “liquid” is just BS. You can pull every dollar out of all of your retirement accounts tomorrow if you want. Yes, it will cost you something, but it will cost you something to pull everything out of a life insurance policy, too.
#3 You are limited to how much you can invest.
This is true, but the reason the limitations are in place is BECAUSE IT'S SUCH A GOOD DEAL. There is not a corresponding limit in the tax code on life insurance policies (perhaps because they aren't a good deal), but there is still a de facto limit. Go ahead: try to buy a $100 million life insurance policy. They won't let you do it unless you have enough income to justify it. A doctor might not even be able to get a life insurance policy with a $10 million face value.
#4 Your money is not guaranteed against loss by a financial institution.
This is not necessarily true. If you want to invest your retirement accounts into CDs or annuities, you can get guarantees against loss. However, the point is that you don't actually want those guarantees because they cost too much in the form of lower returns.
#5 You are required to report your earnings to the IRS when you withdraw the money.
This one is true. Even though you don't have to pay taxes on qualified Roth IRA withdrawals, they are reported on Form 1040 line 4a. Tax-deferred account withdrawals are taxable, of course. But you know what? If you surrender your life insurance policy with a gain, you will also have to report that. You can borrow against your life insurance policy, car, brokerage account, or house and not have to report that money as income, because it isn't.
Now let's look at what the agent says about
TFRAs cash value life insurance policies.
#1 You don't pay tax on principal or growth. Ever!
Unless you surrender it, and it has gains.
#2 You participate in the uncapped growth of the stock market with a ZERO FLOOR.
The most important part of that vague reference to an index universal life policy is the word “participate.” What does that mean exactly? What it means is you're giving up some of the upside to eliminate the downside. What happens in reality is that you give up so much of the upside that you end up with whole life-like returns in the long run.
#3 Your money is liquid.
We already addressed this one. But my favorite part is the half-truth here: “You can withdraw any amount at any time without penalty.” That's true. But you can't withdraw any amount at any time tax-free. Funny how that got left out.
#4 You are not required to report earnings to the IRS.
This one really plays on the distrust of the government that most of us have to a certain extent. But the IRS doesn't classify income inside retirement accounts or a life insurance policy as taxable income because it isn't. If you don't take money out of a retirement account, you don't pay taxes on it. If you don't take money out of an insurance policy, you don't pay taxes on it. The only difference here is you can borrow against the insurance policy tax-free but not interest-free (like your car, house, and brokerage account) and you can't borrow against a retirement account.
My next few screenshots (again that I deleted prior to publication) came from a survey you were supposed to take to determine if a TFRA was right for you. You would think this survey would ask about health problems and dangerous hobbies, important aspects of qualifying to purchase life insurance. Nope, the survey simply asked if you believed the sales pitch you had already been given and whether you had at least $1,000 a month to invest. It was a two-question survey followed by the opportunity to sign up for an appointment with the agent.
I'm still mad at the agent and others pulling the same stunt, but it just wasn't worth the legal hassle to run this post as it was originally written. Hope you still found it useful.
The Bottom Line
7702 Plans and TFRAs are just marketing terms for cash value life insurance policies. Ask yourself why an agent is trying to hide what they are doing by calling it a name you don't recognize. Run, don't walk, from any “advisor” who feels like they have to hide what they're doing behind vague terms like these. If you don't already know why a cash value life insurance policy is inappropriate for the vast majority (including doctors), start here (and then maybe read this).
What do you think? Had you heard of 7702 Plans and TFRAs before? What can white coat investors do to immunize themselves against falling for pitches like these? Comment below!