7 Pay Test: The Seven Pay Test and Life Insurance

Key Takeaway

The 7 pay test refers to how the government determines if your life insurance has become a modified endowment contract (MEC). While it may be tempting to put as much money into your life insurance policy as possible, contributing too much to your account can turn your policy into a MEC. Once your account is turned into an MEC, it typically cannot be undone. MECs usually hold different tax implications and cash value access than typical insurance policies.

Share:
7 pay test life insurance MEC
9/14/2024

What Is the Seven-Pay Test?


The ‘seven-pay test’ simply refers to how the government determines if your life insurance becomes a MEC. This test generally limits how much you as a policyholder can deposit each year during the first seven years of your policy. Hence, the ‘seven-pay test.’

What Is the Seven-Pay Rule?


The seven-pay rule is essentially your MEC deposit limit. If you deposit more than your MEC limit, you can run the risk of converting your life insurance policy into a MEC. Let’s look at an example:

In this example, if you open a $250,000 permanent life insurance policy with a $5,000 MEC limit, that means you can only deposit $5,000 per year for the first seven years of your policy. If you deposit more than that $5,000 during any of those seven years, the government may consider your policy an MEC, which could impact your taxes.

However, if there’s an accidental overage, you have time to correct it. The Internal Revenue Service (IRS) typically gives a sixty-day grace period to insurance providers to return the overfunded amount to you. If they return the overage before the sixty days are up, it generally will not trigger a MEC.

Additionally, changes made to your policy can cause new seven-pay tests to be run. For example, if you make a material change to your policy like reducing the death benefit, the IRS may run another test. 

7 Pay Test - Non-MEC vs. MEC Policies Comparison Table

Category/Aspect

Non-MEC Policy

MEC Policy

Taxation on Loans

Policy loans are tax-free and not considered withdrawals.

Policy loans are also tax-free, but if the policy lapses, the outstanding loan balance could trigger a taxable event.

Early Withdrawal Penalties

No penalties for early withdrawal (before 59½) as long as they are considered loans or withdrawals of basis.

Withdrawals before age 59½ incur a 10% penalty in addition to income tax.

Contribution Limits

Contributions are limited by the 7-pay test to avoid MEC status.

No strict contribution limits after policy becomes a MEC, but overfunding can still lead to taxation issues.

Death Benefit

Death benefit is tax-free for beneficiaries.

Death benefit remains tax-free for beneficiaries.

Use in Retirement Planning

May offer tax advantages like tax-free loans, but limited by contribution rules.

Often used for tax-deferred growth, but early withdrawals trigger penalties and taxes.

Flexibility in Funding

Must adhere to the 7-pay rule to avoid MEC status; limited flexibility in overfunding.

Allows for more overfunding without concern for the 7-pay rule, but MEC taxation applies.

Policy Changes

Material changes (e.g., reducing death benefit) can trigger a new 7-pay test.

Material changes may trigger a new 7-pay test, and policy remains a MEC.

Policy Reversal

Policy remains non-MEC as long as 7-pay test is passed each year.

Once a policy becomes a MEC, it typically cannot be undone and remains a MEC permanently.

How Is the Seven-Pay Test Calculated for Life Insurance?


We recommend checking your policy documents for the most accurate information regarding your yearly MEC limit. This is because these limits vary from policy to policy, and your specific contract documents should tell you how much you can pay into your policy each year before triggering the MEC status.

Generally, the MEC limit is based on the annual premium that would pay up the policy after seven annual premiums. When the IRS issues its pay test, it compares the total premiums paid in the first seven years with what would be needed to pay it in full.

Can the Seven-Pay Rule Apply to a Universal Life Policy?


It can, because a universal life insurance policy accumulates cash value, the seven-pay rule applies to it. Many permanent life insurance contracts may qualify for the seven-pay rule. Always check the information on your life insurance policy to know what your MEC threshold is so you don’t go over it. In many cases, your insurance company will let you know if you have overpaid and have exceeded that limit.

Other examples of life insurance policies that can become an MEC include:

  • Whole life insurance policies
  • Variable life insurance policies
  • Indexed universal life insurance policies
  • Term life policies, however, usually don’t qualify for the seven-pay test. This is because these policies do not accumulate cash value. Keep in mind that MECs are permanent life insurance policies that are funded beyond the federal tax limits.



Understanding MECs in Insurance


Insurance policies and MECs have different tax implications that are important to consider when you are doing financial planning. This is because life insurance policies typically offer certain perks, such as taking a loan out against your policy, early withdrawal, and tax benefits in addition to the death benefit.

However, your policy turning into an MEC isn’t inherently negative. Some policyholders enjoy certain benefits that MECs can provide, such as acting as an alternative or supplement to annuities in their retirement and estate planning.

You may be able to withdraw money from an MEC once you’ve retired or after the age of fifty-nine-and-a-half. These earnings may be treated as ordinary‒taxable‒income. However, MECs are still generally considered life insurance products. This means you may still be able to leave a tax-free death benefit to your survivors.

Unlike with many life insurance products, withdrawing from an MEC early can trigger financial penalties. This means you may need to pay 10% of your withdrawal as a penalty in addition to the income tax.

Taxes and MECs


If your policy turns into an MEC, it can be taxed differently than a standard life insurance policy. For example, if you withdraw early from your MEC, the earnings will come out first and they can be subject to federal income tax at your regular rate. If you exhaust your earnings, you will tap into the principal balance which cannot be double-taxed.

Your principle is based on your contributions, including the monthly premium you pay which is already taxed. Additionally, your beneficiaries may still receive the tax-free financial inheritance through the original policy’s death benefit.

A MEC may be a financial option to consider if you are looking for tax-deferred growth in your cash value account. Some cash value accounts are tied to stocks, which can mean any interest, capital gains, and dividends can accumulate without being subject to taxes. Keep in mind that this may only apply until you withdraw from the account.

When you make your monthly payment to a standard insurance policy, you are still subject to high contribution limits because you’re trying to avoid MEC status. However, with an MEC, you don’t need to worry about that. 

Additionally, MECs don’t typically have the same annual contribution limits as IRAs or 401(k)s. If you’re invested in your financial health, MECs can be considered if you want to invest large sums of funding into a tax-advantaged account.


EL01603A64 (8-24)

The information above is for educational use only and does not represent insurance, tax, or legal advice. It is not a recommendation or solicitation to buy insurance. Please talk to your licensed insurance agent for more information about life insurance and your needs. Please consult with the appropriate professional for tax or legal advice. Guarantees are backed by the claims-paying ability of the issuing insurance company.


Article Author: Meredith Bell
Author Bio: Meredith joined Everly in 2022 and has 20+ years of experience in the life insurance industry. She has held various roles in advertising, marketing, communications, sales and distribution support, and product development. Outside of the office, Meredith lives with her daughter Kennedy and their dog Mavis. Meredith enjoys cooking, camping, gardening, hiking, and bourbon (though not always at the same time). She is a live music enthusiast and an avid reader. Her favorite quote is by Thomas Jefferson: "I cannot live without books." Meredith agrees, but would add cheese, movies, and dogs to that list.

Policies are issued by Everly Life Insurance Company (“Everly Life”), Topeka, KS. Everly Life is not licensed in the state of New York and does not solicit or transact business in New York.

CalendarLive support: Mon–Fri, 8am–5pm CT

© 2023 Everly, LLC