If a life policy does not pass the 7-pay test, what does that policy become?

When a life insurance policy fails the 7-pay test, it is classified as a Modified Endowment Contract (MEC). The 7-pay test is designed to ensure that the cash value accumulation within the policy does not exceed a certain limit compared to the premiums paid in the first seven years. If a policy violates this limit, it is designated as a MEC.

The significance of a policy being a MEC is that it subjects the policyholder to less favorable tax treatment. Distributions, including policy loans and withdrawals, are taxed on a last-in, first-out (LIFO) basis, meaning that any gains are considered taxable income before any return of principal, which can lead to unexpected tax burdens for the policyholder.

In contrast, other policy types like universal life, term, or whole life have different tax implications and characteristics. For instance, universal life insurance offers flexible premiums and death benefits but maintains distinct tax treatments when structured correctly outside of the MEC regulations. Term policies, focused primarily on providing pure death benefit without cash value accumulation, are not assessed under the 7-pay test at all. Whole life policies typically stay compliant with the 7-pay test if structured appropriately to avoid becoming MECs.

Understanding the implications of a policy being classified as a