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To avoid being declared a modified endowment contract, a life insurance policy must meet the ?7-pay? test. This test calculates the annual premium a life insurance policy would need to be paid up after seven level annual premiums. (When a life insurance policy is ?paid up,? no further premiums are due.)

It is possible that a contract that requires seven level annual premiums will fail the 7-pay test because the statutory net level premium will be less than the actual premium paid. Once a policy has failed the 7-pay test, it becomes a MEC and remains a MEC for the life of the contract.

Modified Endowment Contracts offer potential benefits, such as tax-deferred growth and flexibility in premium payments. But it also comes with disadvantages, including tax implications on policy loans and withdrawals, as well as the potential for higher fees and costs compared to other investment vehicles.

Under a Modified Endowment Contract, what are the likely tax consequences? The tax consequence of a modified endowment contract is pre-death distributions are likely to become taxable. Premiums on limited payment whole life insurance are paid for a limited number of years, but the benefits last a lifetime.

The seven-pay test helps the IRS determine whether your life insurance policy will be converted into an MEC. It compares the total premiums you paid in the first seven years of the policy with what you'd need to pay it in full. If your payments exceed what's needed, your policy becomes recognized as an MEC.

MEC withdrawals also typically incur a 10% tax penalty if you take out the money before turning 59½ years old. The 10% only applies to the gains, but because the gains are withdrawn first, you'll likely pay the penalty.

What Are the Likely Tax Consequences of an Early Withdrawal Under an MEC? Withdrawals are taxed similarly to those of a non-qualified annuity. For withdrawals before the age of 59½, a penalty of 10% may apply. 6 As with traditional life insurance policies, MEC death benefits aren't subject to taxation.

The seven-pay test helps the IRS determine whether your life insurance policy will be converted into an MEC. It compares the total premiums you paid in the first seven years of the policy with what you'd need to pay it in full. If your payments exceed what's needed, your policy becomes recognized as an MEC.