What happens when a life insurance policy fails the 7 pay test?

When a life insurance policy fails the 7 pay test, it becomes classified as a Modified Endowment Contract (MEC). The 7 pay test is a key part of the tax regulations concerning life insurance policies, specifically designed to determine whether the premiums paid into the policy exceed a certain limit relative to the death benefit over the first seven years.

When a policy is classified as a MEC, it loses certain tax advantages that are typically available to life insurance products. Specifically, withdrawals and loans taken from the MEC may be subject to income tax, and if the policyholder is under age 59½, they could also incur a 10% penalty on those distributions. Understanding this classification is crucial for insurance professionals and policyholders alike, as it impacts both the tax treatment and the overall efficiency of the policy in meeting the needs of the insured and their beneficiaries.