Seven-Pay Test
The IRS limit comparing cumulative premiums paid in the first seven years with the net level premium for a 7-pay policy; exceeding it makes the contract a MEC.
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Practice This Concept
A life insurance policy fails the seven-pay test under IRC Section 7702 and becomes a modified endowment contract. Which consequence follows?
Withdrawals and loans are taxed on a LIFO basis, gain first, with a 10% penalty on distributions before age 59 and a half — A modified endowment contract (MEC) is created when a life insurance policy is funded faster than the seven-pay test permits. Because the contract is overfunded as an investment, withdrawals and loans are taxed on a last-in, first-out (LIFO) basis, meaning taxable gain is distributed first, and distributions before age 59 and a half are subject to a 10% penalty. The death benefit, however, remains income-tax-free to the beneficiary under IRC Section 101(a), and the contract continues to operate as life insurance.
National insurance concept
A life insurance policy fails the seven-pay test and becomes a modified endowment contract (MEC). What happens to withdrawals from the policy?
They are taxed on a LIFO basis — gain deemed distributed first — and a 10% penalty may apply before age 59½ — A MEC, defined in IRC §7702A, is a life policy whose premiums exceed the seven-pay limit. MEC status removes the favorable treatment of cash-value distributions: withdrawals and loans are taxed on a LIFO basis, meaning distributions are taxable income to the extent of gain before any return of basis, and a 10% additional tax applies on taxable amounts taken before age 59½. The death benefit, however, remains income-tax free under IRC §101. Losing the death-benefit exclusion, FIFO treatment, or treating the contract as no longer life insurance are all incorrect.
National insurance concept
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