The seven pay test is used to determine if a permanent life insurance policy is a modified endowment contract (MEC). Anytime in the first seven years, total premiums paid can NOT exceed the amount which would be required to pay up the policy in seven years. If a policy fails the seven pay test it becomes a MEC.
When a life insurance policy becomes a MEC it loses its “first-in, first-out” tax treatment. This treatment is one of the desirable features of permanent life insurance. Losing this treatment is usually not beneficial to the policyholder because cash value loans and withdrawals become taxable immediately rather than remaining tax-preferred as with non-MEC policies.
The seven pay test is also used by the internal revenue service (IRS) to evaluate the total premiums paid into a permanent life insurance policy compared to how much cash value is being developed in the policy.
In universal life insurance policies, (traditional, indexed, and variable products), cash values accumulate when the policy is “overfunded.” This overfunding can occur by making larger premium payments out-of-pocket that exceed what is needed to cover the cost of insurance. Another way for cash values to accumulate in universal life policies is via the interest earned on overpaid premiums. Finally, overpaying a policy loan can also create a MEC. Ironically, regardless of how cash value accumulates, if the cash value accumulation exceeds the seven pay test limitations, set by the IRS, the policy becomes a MEC.
In whole life insurance policies, the cash value grows as a result of equity being developed in the policy. Unlike universal life insurance products, whole life products actually convert base insurance to paid-up insurance over time. As base insurance becomes paid-up insurance, there is no longer any premium owed on the paid-up portion of the contract and thus it becomes equity for the policyholder.
A surrender of paid-up insurance would require the insurance company to refund the policyholder for any paid-up insurance surrendered. If the paid-up insurance is not surrendered, the surrender value accumulates resulting in ever-increasing cash values as more base insurance is converted to paid-up insurance.
As with universal life products, whole life insurance policies can be overfunded. Exceeding the IRS seven pay test, however, will make a whole life policy become a MEC. In order to create a MEC with a whole life policy, a policyholder must;
Once a policy passes the first seven years and hasn’t become a MEC, the policy can still fail the seven-pay test.
At any future date, if any of the benefits, premiums, or terms are altered, changed, or modified, the policy must then pass the seven pay test over again. Therefore, a policy that has been altered, changed, or modified affecting any of the benefits, premiums, or terms of the contract, must once again pass the seven-pay test to avoid becoming a MEC.
This means the seven-pay test is a test that is perpetually applied to permanent life insurance contracts. As such, the seven pay test is something all permanent policyholders should be aware of because once a policy becomes a MEC, prompt action must be taken to reverse this status if you want to avoid negative tax treatment in all future years.
Most of the time policy owners want to avoid MEC status, but occasionally there is good reason to intentionally create a modified endowment contract, which does not pass the seven-pay test, to accomplish specific financial goals.
At Life Benefits, we specialize in designing term and whole life insurance policies to solve the financial needs of our clients. Understanding the limitations of the seven-pay test on policy design is one of the things we handle for you, so you don’t have to get into the weeds.
Call our office at 702-660-7000 and ask for a strategy session to see how a policy can be designed to fit your needs.