Key Takeaway
The 7 pay test refers to how the government determines if your life insurance has become a modified endowment contract (MEC). While it may be tempting to put as much money into your life insurance policy as possible, contributing too much to your account can turn your policy into a MEC. Once your account is turned into an MEC, it typically cannot be undone. MECs usually hold different tax implications and cash value access than typical insurance policies.
What Is the Seven-Pay Test?
The ‘seven-pay test’ simply refers to how the government determines if your life insurance becomes a MEC. This test generally limits how much you as a policyholder can deposit each year during the first seven years of your policy. Hence, the ‘seven-pay test.’
What Is the Seven-Pay Rule?
The seven-pay rule is essentially your MEC deposit limit. If you deposit more than your MEC limit, you can run the risk of converting your life insurance policy into a MEC. Let’s look at an example:
In this example, if you open a $250,000 permanent life insurance policy with a $5,000 MEC limit, that means you can only deposit $5,000 per year for the first seven years of your policy. If you deposit more than that $5,000 during any of those seven years, the government may consider your policy an MEC, which could impact your taxes.
However, if there’s an accidental overage, you have time to correct it. The Internal Revenue Service (IRS) typically gives a sixty-day grace period to insurance providers to return the overfunded amount to you. If they return the overage before the sixty days are up, it generally will not trigger a MEC.
Additionally, changes made to your policy can cause new seven-pay tests to be run. For example, if you make a material change to your policy like reducing the death benefit, the IRS may run another test.
How Is the Seven-Pay Test Calculated for Life Insurance?
We recommend checking your policy documents for the most accurate information regarding your yearly MEC limit. This is because these limits vary from policy to policy, and your specific contract documents should tell you how much you can pay into your policy each year before triggering the MEC status.
Generally, the MEC limit is based on the annual premium that would pay up the policy after seven annual premiums. When the IRS issues its pay test, it compares the total premiums paid in the first seven years with what would be needed to pay it in full.
Can the Seven-Pay Rule Apply to a Universal Life Policy?
It can, because a universal life insurance policy accumulates cash value, the seven-pay rule applies to it. Many permanent life insurance contracts may qualify for the seven-pay rule. Always check the information on your life insurance policy to know what your MEC threshold is so you don’t go over it. In many cases, your insurance company will let you know if you have overpaid and have exceeded that limit.
Other examples of life insurance policies that can become an MEC include:
- Whole life insurance policies
- Variable life insurance policies
- Indexed universal life insurance policies
- Term life policies, however, usually don’t qualify for the seven-pay test. This is because these policies do not accumulate cash value. Keep in mind that MECs are permanent life insurance policies that are funded beyond the federal tax limits.
Understanding MECs in Insurance
Insurance policies and MECs have different tax implications that are important to consider when you are doing financial planning. This is because life insurance policies typically offer certain perks, such as taking a loan out against your policy, early withdrawal, and tax benefits in addition to the death benefit.
However, your policy turning into an MEC isn’t inherently negative. Some policyholders enjoy certain benefits that MECs can provide, such as acting as an alternative or supplement to annuities in their retirement and estate planning.
You may be able to withdraw money from an MEC once you’ve retired or after the age of fifty-nine-and-a-half. These earnings may be treated as ordinary‒taxable‒income. However, MECs are still generally considered life insurance products. This means you may still be able to leave a tax-free death benefit to your survivors.
Unlike with many life insurance products, withdrawing from an MEC early can trigger financial penalties. This means you may need to pay 10% of your withdrawal as a penalty in addition to the income tax.
Taxes and MECs
If your policy turns into an MEC, it can be taxed differently than a standard life insurance policy. For example, if you withdraw early from your MEC, the earnings will come out first and they can be subject to federal income tax at your regular rate. If you exhaust your earnings, you will tap into the principal balance which cannot be double-taxed.
Your principle is based on your contributions, including the monthly premium you pay which is already taxed. Additionally, your beneficiaries may still receive the tax-free financial inheritance through the original policy’s death benefit.
A MEC may be a financial option to consider if you are looking for tax-deferred growth in your cash value account. Some cash value accounts are tied to stocks, which can mean any interest, capital gains, and dividends can accumulate without being subject to taxes. Keep in mind that this may only apply until you withdraw from the account.
When you make your monthly payment to a standard insurance policy, you are still subject to high contribution limits because you’re trying to avoid MEC status. However, with an MEC, you don’t need to worry about that.
Additionally, MECs don’t typically have the same annual contribution limits as IRAs or 401(k)s. If you’re invested in your financial health, MECs can be considered if you want to invest large sums of funding into a tax-advantaged account.
