Permanent life insurance was long viewed as offering investors an attractive tax break: cash-value growth was tax-deferred while loans were taxed according to the last-in first-out method. But with most policies featuring cash values now failing the seven-pay test and thus being classified as modified endowment contracts (MECs), investors may lose some tax advantages of permanent life insurance investments.
Policies may become Medical Examination Contracts when their premiums exceed IRS guideline limits or any change occurs in benefits, premiums or contract terms resulting in MEC status.
The 7-pay test is a federal law
The seven-pay test is an IRS strategy designed to verify that life insurance policies haven’t been overfunded, discouraging their use as investment vehicles and guaranteeing premium payments go toward paying the death benefit only. MEC status applies when an insurance policy exceeds IRS contribution limits, which are determined by calculating how much premium would be necessary over seven years to fully fund a policy, plus interest earned on such payments. The seven-pay test is used on universal life policies (traditional, indexed and variable) to make sure their cash values don’t go beyond coverage levels intended.
Once a life insurance policy becomes MEC, some of its tax advantages become lost. Permanent life insurance typically benefits from first-in/first-out tax system which ensures when withdrawing or borrowing against its cash value you receive your benefit before taxes are deducted; with MEC policies however all cash withdrawals and loans are immediately taxed as income.
An income-first taxation (MEC) policy may become eligible due to any number of circumstances, including reduction in face amount or material change such as increase in death benefit. When this occurs, the seven-pay test must be recalculated over its first seven contract years as though originally issued at its new death benefit level and income-first taxation will apply both during those seven contract years as well as any future distributions made after MEC income-first taxation has taken place.
People tend to avoid making their life insurance policies multi-estate contracts (MECs), but there may be valid financial arguments for doing so. One disadvantage associated with MECs is that they may be difficult and costly to convert back to non-MEC status – both potentially costing policyholders financially as well as decreasing death benefits – so before making such a decision it is crucial that all potential costs and benefits of becoming an MEC are carefully considered before making this decision.
It is a rule of thumb
The Seven-Pay Test, set forth by the Internal Revenue Service (IRS), serves to prevent overfunding of cash value life insurance policies. It measures whether premium payments exceed what’s necessary to cover payments in seven years; failing this test makes a policy into an MEC (modified endowment contract), so in order to prevent that status being attained you must keep your annual premium within the IRS guideline premium limit – not always easy given factors such as your policy’s cash value accumulating over time affecting its premium limit.
The IRS also establishes minimum death benefits and maximum cash values for permanent life insurance policies, considered MEC if their cash value account exceeds this minimum or maximum value. Furthermore, death benefits must represent at least seven times annual premium payments within seven policy years; additionally annual premiums cannot exceed either guideline single premium or guideline annual premium limits, in order to be tax-favored.
Alongside the seven-pay test, certain life insurance policies may also be subject to MEC risk, which occurs if premiums exceed their required levels in early years, whether through extra payments or interest accruals. Furthermore, MEC risk exists if cash value exceeds IRS limits which could incur an IRS withdrawal penalty and any changes in benefits, premiums or contract terms require them to pass a new seven-pay test to remain non-MEC status.
If you purchase a permanent life insurance policy that does not fall into this category, it’s important to understand that once it has been designated MEC it cannot be reversed. Instead, excess premiums paid can usually be returned within 60 days after contract year ends by your insurer.
It is a limit
TAMRA of 1988 established the seven-pay test to help determine whether or not permanent life insurance policies fall under modified endowment contracts (MEC), which limit tax benefits associated with cash value withdrawals and loans. If an MEC policy’s cumulative premium exceeds an IRS limit within seven years it is considered an MEC; this limit is determined by how much it would cost to pay off all the premiums in that time.
MEC status typically poses no issues for most people; however, overpaying life insurance policies could pose one such threat. Many individuals overpay in order to boost the cash value accounts. Overpayment could violate the seven-pay test and trigger IRS conversion into an MEC policy. If this concerns you, check with your insurer; most carriers monitor how much is being paid each year and notify customers if their premium payments exceed what’s allowed; they may offer to refund any additional amounts paid and allow for conversion without further complications.
The seven-pay test is a premium restriction imposed upon life insurance policies with cash value components purchased after June 20, 1988. Insurance companies typically set annual premium limits based on how much it would take to “pay up” the policy in seven level annual premiums (when no further premiums are owed). A policy is considered an MEC when its cumulative net level premium exceeds the statutory level premium threshold. MEC status cannot typically be reversed once declared; however, if your policy undergoes material changes such as reduced coverage, such as being closed out early or reduced in size, then the seven-pay test can reset. Most people don’t need to worry too much about this since most permanent life insurance policies don’t overpay significantly; but it is worth knowing in case you intend on purchasing another policy in the near future.
It is a requirement
Some life insurance policies with cash value components can become overfunded and classified as modified endowment contracts (MEC). To test whether they are overfunded, the IRS uses its seven-pay test; to pass, any policy must not pay more than it would need to in seven level premium payments over seven years.
Overfunding life insurance policies is common, as any additional funds that go into the cash account may increase both death benefits and policy value; however, this money may also trigger an MEC designation from the IRS. They have set an annual limit on how much can be put into cash accounts during each of the first seven years before failing the seven-pay test and being classified as MECs.
The seven-pay test is determined using the statutory net level premium, calculated with mandated interest, mortality and expense assumptions. A life insurance contract fails the seven-pay test when its total premium payments surpass that of its first seven contract years and exceeds the statutory net level premium by more than 20%; once this occurs it becomes a modified endowment contract (MEC), remaining so for its entire existence; should such an MEC contract be exchanged for another contract it will undergo the same testing process again.
TAMRA of 1988 sets limits on how much permanent life insurance policies can be paid into during any seven year period without being classified as Modernized Excess Coverage policies and thus losing their preferential tax treatment. If an excess premium payment occurs, TAMRA classes it as an MEC instead and loses its favorable tax treatment. The seven-pay test is meant to dissuade investors from purchasing permanent life insurance solely to reduce capital gains taxes, but most people who purchase life insurance pay a minimum required premium and so it is unlikely many policies would fail this test. While purchasing life insurance is fine if only used to cover final expenses, for those using their policy as an investment vehicle this test should be carefully considered.