A seven-pay test worked through with round numbers

Here is the whole seven-pay test in one sentence: in each of the first seven years of a permanent life insurance policy, the total premium you have paid so far cannot be larger than the insurer's seven-pay premium multiplied by the number of years that have gone by. If it is, the policy becomes a modified endowment contract, or MEC, and loans and withdrawals are taxed in a harsher way for as long as you own it.

That sentence is easy to nod at and hard to use. This post works the test with round numbers, the way you would work it with a pencil. You can repeat the steps with your own figures once you have the one number only your insurer can supply. Every figure below is a hypothetical chosen for easy arithmetic. None of them is a real premium limit, and a real policy's limit depends on the insured's age, the face amount, the type of policy and assumptions fixed by the tax code.

For background on why the MEC rules exist and how a MEC is taxed, read modified endowment contracts and the 7-pay test. This post is the arithmetic companion.

What the test measures

The seven-pay test comes from section 7702A of the Internal Revenue Code. It sits on top of the basic definition of life insurance in section 7702. A policy that qualifies as life insurance under 7702 keeps its tax advantages. The seven-pay test then asks a second question: has the policy been funded faster than a seven-year payment plan would allow?

The yardstick is the seven-pay premium, sometimes called the seven-pay limit or MEC premium. It is the level annual premium that would, after seven payments, fully pay up the policy's guaranteed benefits. The insurer computes it using assumptions set by the tax code, so you cannot reproduce it from a brochure. You ask the insurer, or find it on the policy's illustration or in the policy's administrative records. Many universal life illustrations print it as the "MEC premium" or "seven-pay premium."

Three facts about that number are worth knowing before the arithmetic.

• A bigger death benefit means a bigger limit. The limit is tied to the benefits the policy provides. For the same insured, a higher face amount lets you pay more premium without tripping the test.
• Age moves it. For the same face amount, an older insured generally has a higher limit than a younger one.
• It is set at issue and can be reset. The limit is figured when the policy starts. Certain changes to the policy, such as a benefit reduction in the first seven years or a material change, force a new calculation. The post How a benefit increase or a rider can quietly turn a policy into a MEC covers those changes.

The worksheet

You need four numbers and one rule.

1. L, the annual seven-pay premium from the insurer.
2. Years elapsed, counted in contract years from the policy date. A payment made in the first twelve months is a year-1 payment.
3. Cumulative premiums paid so far. For the test, this is premiums paid, reduced by amounts distributed that were not taxable (for example, a dividend taken in cash or a non-taxable withdrawal). Ask the insurer how it treats those items.
4. The running limit, which is L times the number of years elapsed.

The rule: at every point in the first seven contract years, cumulative premiums paid must be no larger than the running limit. Your headroom is the running limit minus cumulative premiums paid. Positive or zero headroom passes. Negative headroom fails.

Fill in the first column from L, track the second column from your payment history, and subtract. The rest of this post shows it filled in.

A worked example: Jordan's first three years

Say Jordan, a hypothetical 42-year-old, buys a permanent policy with a $400,000 face amount. Jordan asks the insurer for the seven-pay premium and is told it is $8,000 a year. That number is invented for the example.

Jordan plans to pay $8,000 in year 1 and $6,000 a year after that, and then receives a work bonus.

Year 1. The running limit is $8,000 x 1 = $8,000. Jordan pays $8,000. Cumulative paid is $8,000. Headroom is $8,000 - $8,000 = $0. This passes, with nothing to spare.

Year 2. The running limit is $8,000 x 2 = $16,000. Jordan pays $6,000, so cumulative paid is $8,000 + $6,000 = $14,000. Headroom is $16,000 - $14,000 = $2,000. Passes.

Year 3. The running limit is $8,000 x 3 = $24,000. Jordan intends to pay the regular $6,000 and, because of the bonus, a one-time extra $6,000, a total of $12,000 this year. Cumulative paid would be $14,000 + $12,000 = $26,000. Headroom is $24,000 - $26,000 = -$2,000. This fails.

The payment that tips the policy is the part of year 3's total that crosses the line. In this example, the extra payment of $6,000 was $2,000 too large. Jordan could have added up to $4,000 in year 3 without a problem, because $6,000 regular + $4,000 extra = $10,000, and the cumulative total would then be $14,000 + $10,000 = $24,000, exactly on the running limit.

That is the formula to remember for any year:

Largest total payment this year = running limit for this year - cumulative paid before this year.

For year 3: $24,000 - $14,000 = $10,000. Anything above it fails.

What happens at the failure

A policy that fails the test is a MEC. But the tax code gives a short window to undo the excess, covered in the guide: if the excess premium, with the interest or other income earned on it, is returned to the owner within 60 days after the end of the contract year in which it was paid, the policy is treated as if the excess had never been paid. The policy does not become a MEC. In Jordan's case the excess is $2,000, and the refund would include whatever the $2,000 earned.

Whether an insurer will do this automatically, or at all without the owner's request, varies. Many insurers monitor for it and send a warning or refund, but some ask the owner to confirm what they want. The details and what to do if the window is missed are in What you can still do after your policy becomes a MEC.

Two more points make the arithmetic less forgiving than it looks.

• Distributions near a failure count. A distribution (a withdrawal or loan) made in the two years before a failure is treated as made in anticipation of it and can be taxed under the MEC rules.
• A refund is not a free withdrawal. The returned excess is a correction, and it is the insurer's calculation that decides what counts as interest on the excess. Get the figures in writing.

The difference MEC status makes: a numeric look

Suppose Jordan did not correct it, and the policy became a MEC in year 3. Say Jordan stops paying premiums at that point, so that total premiums paid are $26,000, and years later, at age 55, the cash value is $41,000. The gain in the policy is $41,000 - $26,000 = $15,000.

Jordan takes a $20,000 policy loan.

On a non-MEC policy, the same loan is generally not income as long as the policy stays in force. On a MEC, loans and withdrawals are taxed on a gain-first basis, meaning the $15,000 of gain comes out before the $5,000 that returns Jordan's own premiums, and the extra 10 percent tax can apply to the taxable part if the owner is under age 59½. These are the points in the modified endowment contracts and the 7-pay test guide and how cash value is taxed: withdrawals, loans and surrenders. A tax professional can confirm how they apply to a real policy.

What does not change: the death benefit is still generally income-tax-free to the beneficiary, and cash value still grows tax-deferred. A MEC is not a defective policy. It is a policy with different rules for the money you take out while living. For some owners, especially those who do not plan to touch the cash value, that is an acceptable result.

A second case: the lump sum

Say Priya, another hypothetical buyer, has an inheritance of $40,000 and wants to put all of it into a new policy. Her insurer says the seven-pay premium for the policy she is considering is $8,000.

• Year 1 running limit: $8,000 x 1 = $8,000.
• Her planned payment: $40,000.
• Result: $40,000 is $32,000 over the year-1 limit. The excess is five times the limit ($40,000 / $8,000 = 5). She would be paying five years of premium at once.

To keep the policy from being a MEC, Priya could pay $8,000 each year for five years ($8,000 x 5 = $40,000), or a larger policy could be designed so the limit is higher. Or she could choose to accept MEC status because she does not plan to borrow. The point is that she should know before she pays. Paying first and asking afterward is how accidental MECs happen.

A third case: cutting the death benefit

The test can fail because of something you take away, not something you pay. Say Sam, hypothetically, has the same kind of policy as Jordan, a $400,000 face amount and an $8,000 seven-pay premium, and pays exactly $8,000 in each of the first two years. That is $16,000 against a running limit of $16,000 at the end of year 2, a pass.

At the start of year 3, to save money on future charges, Sam asks the insurer to cut the face amount to $250,000. The insurer recalculates the seven-pay premium for the lower benefit. Suppose, for the example, that the new figure is $5,000. (Real limits do not always scale in a straight line with the face amount, so treat this as an illustration of the method.)

The recalculation is applied as if the lower benefit had been in place from the first day. So the test is rerun over the years already passed:

• Running limit at the end of year 2 under the new figure: $5,000 x 2 = $10,000.
• Premiums Sam actually paid: $16,000.
• Headroom: $10,000 - $16,000 = -$6,000.

Sam's policy fails the test because of a request made on a form, and nothing was paid late. This is why the rule of thumb in the guides is to ask the insurer before reducing coverage in the first seven years. Ask for a written statement of the new limit and the MEC status before the change takes effect. If the insurer will not confirm in advance, ask whether the reduction can be made effective on a later date, after the seven-year period ends.

Odds and ends that trip people up

Monthly payments. The test is about totals, so paying monthly does not change the limit. What it changes is when you reach each total. A policy owner who pays $1,000 a month in year 1 will have paid $8,000 by month eight, and has used all of year 1's room. Payments in month nine through twelve, if made, would fail the test.

Paying ahead. Because the running limit grows only as years pass, a payment made early cannot borrow from a later year. In Jordan's year 1, paying $16,000 on day one would have exceeded the $8,000 limit, even though it would have covered year 2's premium.

Year 8 and beyond. The seven-year period ends after contract year 7. After that, the seven-pay test no longer limits what you pay by itself, although the definition in section 7702, the policy's own rules and the insurer's limits still apply, and a material change can start a new seven-year period. A policy that passed through year 7 without failing is generally safe from this test unless something later resets it.

Term riders and other benefits. Riders can change what the insurer counts when it computes the limit. Ask which benefits are in the calculation.

Statements and notices. Insurers usually send a warning when a payment would create a MEC. Do not rely on it, particularly if your payments are automated or arrive through a bank bill-pay service, since those payments might clear before anyone reads a letter.

When the rules change under you

The worksheet assumes nothing about the policy changes in the first seven years. Real policies do change, and some changes affect the test.

• Lowering the death benefit in the first seven years means the limit is recomputed as if the lower benefit had applied from the start. Premiums already paid are then compared with the lower limit. This is a common cause of an accidental MEC when an owner reduces coverage to cut costs.
• A material change, such as a benefit increase or certain rider additions, can start a new seven-year test.
• A 1035 exchange starts a fresh test on the new contract. The exchange is explained in 1035 exchanges: swapping policies without tax. A policy that was already a MEC stays a MEC after an exchange. The question-and-answer post MEC status and 1035 exchanges: questions and answers goes through the cases.
• Dividends and loans can change the "cumulative paid" figure, because amounts distributed that are not taxable reduce it for the test.

Each of those is a reason to ask the insurer for a status check before making the change.

Questions to ask the insurer before you pay

1. What is the seven-pay premium for my policy, and the date my seven-year period began?
2. How much total premium have I paid for the test, and how are dividends or withdrawals counted?
3. How much can I add this year without exceeding the limit?
4. Does the insurer block, warn about or reverse a payment that would create a MEC?
5. If I plan to lower the death benefit or add a rider, will it reset the test?
6. How do I get written confirmation that the policy is not a MEC, and when will it be updated?

The policy loan calculator can show how a loan grows once you have a policy in force, but it does not test MEC status. For that, you need the insurer's figures.

If you suspect you already crossed the line

Check your policy statement for a "MEC" flag, which many insurers print, and ask the insurer for its current status in writing. If you did cross the line, do not take loans or withdrawals until you understand the tax effect, and read Your policy turned out to be a MEC: what it means and what you can do and What you can still do after your policy becomes a MEC. A fee-only planner or tax professional can help you decide whether the status matters for what you plan to do with the policy.

Key takeaways

• The seven-pay test compares cumulative premiums paid with the seven-pay premium times the number of contract years elapsed, at every point in the first seven years.
• The largest total payment in any year is that year's running limit minus the cumulative amount already paid.
• In the example, a $12,000 payment in year 3 brought the total to $26,000 against a $24,000 limit and tipped the policy into MEC status.
• Returning the excess premium with its earnings within 60 days after the end of the contract year can prevent MEC status; ask the insurer, and ask early.
• On a MEC, loans and withdrawals are taxed gain-first and may carry a 10 percent additional tax before age 59½; the death benefit stays income-tax-free.