If a life insurance policy fails the 7 Pay Test, it loses its status as a life insurance contract and becomes a Modified Endowment Contract (MEC). This failure and reclassification creates a change in several tax aspects of the insurance contract and we will detail all of those changes in this article.
But first, let's understand the purpose of the 7 Pay Test and the intention of these rules regarding life insurance in the United States.
What is the 7 Pay Test? Why Does the 7 Pay Test Exist?
Congressional Bill H.R. 4333 established the Technical and Miscellaneous Revenue Act of 1988 (also referred by a shorthand name TAMRA). Within this bill, Congress made several changes to U.S. Tax Law, and one critical change that effected life insurance policies with cash value. TAMRA established additional rules that limited the amount of premium one could pay towards a life insurance policy relative to its outstanding death benefit. I say additional rules, because earlier in the decade, Congress already established tax laws that officially defined what constituted a life insurance contract and what did not.
The significant change TAMRA established regarding life insurance policies, was a limit on premiums sufficient enough to satisfy all the benefits guaranteed by the contract paid out over a seven year period. That phrasing can be a tad difficult to grasp, so let's dive a little deeper into its intent.
Take for example a life insurance policy with a $1 million death benefit. If we know the expense assumptions made by the life insurer, we can calculate the premium required for any paid-up timeline we wish. We can calculate what the premium must be if we want all the benefits of the policy (i.e. the death benefit) paid-up at age 100 of the insured. We can also calculate what the premium must be, if we want the all the benefits paid-up after 10 years.
The 7 Pay Test essentially says that in order for a life insurance policy to remain life insurance, it cannot receive a premium larger than the premium necessary to make it paid-up after seven years. Thus we have the 7 Pay Test.
The spirit of this restriction was to prevent someone from buying life insurance and making a large initial payment of premium into the policy intentionally to use life insurance as a tax shelter.
Keep in mind that life insurance contracts enjoy many great income tax benefits. Cash values accumulate free of any tax liability so long as they remain inside the policy. The policyholder can remove his/her tax free cost basis in the policy before needing to remove any of the gain. The policyholder can access money in the policy through a policy loan, which carries no tax liability. Lastly, the death benefit of a life insurance policy goes to beneficiaries income tax free (in most cases). In the case of violating the 7 Pay Test and reclassifying a life insurance contract to a Modified Endowment Contract, the policyholder will lose most of the previously mentioned tax benefits.
So the 7 Pay Test exists to prevent the over use of life insurance as a tax shelter, and creates a new set of rules regarding taxes when too much money flows into a life insurance contract.
If I Have a MEC, do I now have to Pay Taxes on my Cash Value?
No, violating the 7 Pay Test and now having a modified Endowment Contract (MEC) does not mean you will immediately owe taxes on your cash value. Even with a MEC, you will still enjoy tax deferred cash value growth. This means accumulation of cash inside a MEC continues to be tax free so long as the cash remains inside the policy. There is, however, and important caveat to this (see the policy loan discussion below).
But there are four very important changes to the tax rules you must understand when you have a Modified Endowment Contract.
First, any money distributed from the policy becomes taxable if there is a gain in the policy. This includes policy loans. So if you have violated the 7 Pay Test and now have a MEC, taking a loan against your cash value will carry an income tax liability provided there is a gain in the policy.
In addition to this point about loans, you should know that if you have a policy loan outstanding and you violate the 7 Pay Test, this could make the balance of the loan amount taxable income to you.
Second, MEC's lose life insurance's FIFO accounting rule and instead must follow LIFO (see the next section for an extended discussion on this topic).
Third, distributions from a MEC prior to age 59.5 are subject to a similar 10% penalty tax found in early Traditional IRA and qualified account distributions.
Lastly, pledging a MEC as collateral for a loan creates a “distribution” from the Modified Endowment Contract that carries all the same tax consequences as a withdrawal or policy loan.
Difference Between FIFO and LIFO in the Context of 7 Pay Rules
Life insurance policies enjoy the First-In First-Out (FIFO) accounting principle. This means that when taking money out of the policy, the dollars that went in fist come out first (i.e. your cost basis). Because you pay life insurance premiums (almost always) with post tax dollars, you do not need to pay taxes again when you take this money out of a life insurance policy.
To use an example, let's say you made 10 payments to a whole life policy for $10,000 each. Your cost basis in the policy equals $100,000. Your cash value in the policy, however is $120,000. If you chose to withdraw $30,000 from the policy, you will first withdraw from the $100,000 you put into the policy yourself. Since you put the money in there, you owe no taxes on the withdrawal.
The alternative accounting principle to FIFO is Last-in First-Out (LIFO). LIFO requires you to take the last dollars into the policy out first. This means any gain on the funds in the policy would come out first. Since these gains represent something earned that has not yet had income taxes paid on it, the distribution with a gain does create a tax liability.
When you violate the 7 Pay Test and have a MEC, you lose the FIFO principle, and must now use the LIFO principle.
Using another example let's say that you have a whole life policy where you had a $100,000 cost basis and $120,000 in cash value, but you also violated the 7 Pay Test and now have a Modified Endowment Contract. Let's also assume that you want to withdraw $30,000 from the policy. You have a $20,000 gain that must come out first in this situation, so $20,000 of your $30,000 withdrawal will count as ordinary income earned by you in the year you make the withdrawal. You will owe taxes on that $20,000 distribution from the MEC.
Does the 7 Pay Test Only Last for 7 Years?
On the surface, it makes sense to assume that the 7 Pay Test only lasts for seven years, but sadly this is not the case. Yes the 7 Pay Tests tracks the payments made to a life insurance policy for a seven year period, but this seven year timeline can be reset whenever the policy goes through a material change. The IRS defines a life insurance material change as an increase in death benefit or any addition of a qualified benefit (e.g. adding most riders to a life insurance policy).
When a material change takes place, the 7 Pay Test timeline resets and a new maximum premium is calculated for MEC compliance for the next seven years.
Can I Violate the 7 Pay Test and Not Know it?
While anything is conceivably possible, it's extremely difficult to violate the 7 Pay Test and not know it. When violation occurs, life insurance companies send pretty significant notification to the policyholder about the violation. The policyholder has the option to reverse the action that caused the violation in order to avoid reclassifying his/her policy as a Modified Endowment Contract. In fact, most policyholders have up to 60 days after the close of the policy year the violation took place to reverse the action that caused the violation and avoid MEC classification of their life insurance policy.
Situations where Violation May Not Matter
While Modified Endowment Contracts are less desirable than regular life insurance contracts, there are circumstances where violating the 7 Pay Test and have a MEC may not be a big deal.
When someone is looking to set funds aside to leave to heirs and has no plans to use the money personally, violating the 7 Pay Test and having a MEC probably doesn't matter very much. The death benefit of a MEC is still tax free to the beneficiaries.
In some unique situations, people use MEC's in order to avoid certain asset disclosure and then cancel the policy before that have a gain in the policy. No gain means no taxes due on canceling the policy.
People have also used heavily over-funded life insurance that immediately violate the 7 Pay Test alternatively to a high-interest savings account. They know that they will pay taxes when they cancel the policy, but the net gain (even after paying taxes) is still higher than cash in the savings account.
Lastly, people who are looking for a single premium life insurance policy will end up violating the 7 Pay Test and having a Modified Endowment Contract. Prior to TAMRA's passage in the late 80's. People could buy single premium life insurance without automatically having a MEC–and many did. Today, if someone wants this type of policy, they get it with the understanding that it will be a MEC from the outset.