In order to avoid being classified as a Modified Endowment Contract (MEC), a policy must pass which test?

A policy must pass the seven-pay test to avoid classification as a Modified Endowment Contract (MEC). This test determines whether the total premiums paid into a life insurance policy during the first seven years exceed the total premiums that would have been paid had the policy been set up as a seven-pay whole life policy.

If a policy fails this test, it is classified as a MEC, which has significant tax implications. Specifically, loans or withdrawals from a MEC may be subject to income taxation and penalties if taken before the insured reaches age 59½. Therefore, insurers and policyholders need to be aware of this test when designing policies to ensure they remain tax-advantaged and are not classified negatively under federal tax law.

Understanding the seven-pay test is crucial for anyone involved in life insurance policy sales or management, as it directly impacts the way policies are structured and how benefits are distributed to policyholders.