What happens if a policy fails the 7-pay test?

• A. If it fails, it automatically terminates.
• B. If it fails, it becomes a standard term policy with no tax consequences.
• C. If it fails, it increases the death benefit.
• D. If a policy fails the 7-pay test, it becomes a MEC and may have tax consequences on withdrawals and loans.

Answer: (D)

The main idea here is how the 7-pay test affects tax treatment of a cash-value life policy. If the policy’s premiums in the first seven years exceed the limit set by the 7-pay test, the policy is classified as a Modified Endowment Contract (MEC). That classification changes how withdrawals and loans from the policy are taxed. Once it becomes a MEC, any access to cash value—whether you pull out money as a withdrawal or borrow against the cash value—is taxed as ordinary income to the extent of the policy’s gains. In other words, the money you take out is more likely to be taxable than it would be under a non-MEC policy. The death benefit, however, generally remains income-tax-free to beneficiaries. MEC status is durable for the life of the policy, so the taxed treatment of distributions continues going forward.