The Seven Pay Test

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.

MEC Policies

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What does MEC stand for?

Minimal Earnings Contract

Monthly Economical Contract

Modified Endowment Contract

A MEC policy is a policy that has been overfunded. In most cases MEC policies are not in the best interest of the policyholder although there are cases where a MEC policy makes sense.

A MEC policy is a policy that has been overfunded. In most cases MEC policies are not in the best interest of the policyholder although there are cases where a MEC policy makes sense.

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What significant change happens to a policy when it becomes a MEC?

Policy loans and withdrawals become taxable

Premiums become adjustable every 6 month period

Death Benefit drops

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 in the best interest of the policyholder. When a policy becomes a MEC policy loans and withdrawals become taxable immediately.

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 in the best interest of the policyholder. When a policy becomes a MEC policy loans and withdrawals become taxable immediately.

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In regard to MEC policies, what is the Seven Pay Test?

A strategy used to pay for seven different MEC policies in the least amount of time conceivable.

The test used for determining whether a policy is a MEC.

A test used by insurance actuaries to determine the maximum premium to cash value ratio.

The seven pay test is used to determine whether a life insurance policy is a MEC. Anytime during a seven-year window, total premiums paid can NOT exceed the specified amount which would classify the policy as a MEC. If premiums exceed this amount the policy becomes a MEC.

The seven pay test is used to determine whether a life insurance policy is a MEC. Anytime during a seven-year window, total premiums paid can NOT exceed the specified amount which would classify the policy as a MEC. If premiums exceed this amount the policy becomes a MEC.

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What types of life insurance policies can become a MEC? (check all that apply)

Whole Life

Term Life

Universal Life

Indexed Universal Life

Variable Universal Life

All permanent insurance policies can become MECs if overfunded. Term insurance does not have any equity buildup which is what a MEC effects. Therefore term insurance can not become a MEC.

All permanent insurance policies can become MECs if overfunded. Term insurance does not have any equity buildup which is what a MEC effects. Therefore term insurance can not become a MEC.

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Is a MEC status permanent?

Yes

No, it can be changed every 5 years

Once a MEC always a MEC. If a policy becomes a MEC unintentionally prompt action must be taken immediately to reverse this status.

Once a MEC always a MEC. If a policy becomes a MEC unintentionally prompt action must be taken immediately to reverse this status.

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MEC policies should be avoided at all costs

True

Not necessarily

Most of the time policy owners want to avoid MEC status. But occasionally there is a good reason to intentionally create a MEC.

Most of the time policy owners want to avoid MEC status. But occasionally there is a good reason to intentionally create a MEC.

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MEC status for Universal Life Insurance Policies

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. 

MEC status for Whole Life Insurance Policies

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;

1. Over fund the policy rider called the paid-up additions rider (PUA or PUAR), or
2. Repay a policy loan with more than the interest the insurance company charged on the loan.

After the First 7 Years

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.

Summary

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.