Seven-Pay Test

Fabien, 47, owns a MODIFIED ENDOWMENT CONTRACT with substantial gain. He asks his producer to identify a circumstance in which he could take money out of the MEC and have the taxable amount escape the additional 10 percent penalty. Which circumstance qualifies?

1. A.He takes the money as a policy LOAN rather than as a withdrawalOn a MEC a loan is treated as a distribution. It is taxed gain first and is subject to the penalty just like a withdrawal.
2. B.He has owned the contract for more than seven years, so the 7-pay period has expiredMEC status is permanent once acquired. The passage of the 7-pay period does not undo it or relieve the penalty.
3. C.He becomes disabled within the meaning of the tax rules before taking the distributionCorrect. Disability is one of the recognized exceptions to the 10 percent penalty on MEC distributions.
4. D.He uses the entire distribution to pay premiums on a different life insurance policyHow the money is spent is irrelevant. There is no premium-payment exception to the penalty.

Why: MEC distributions are taxed gain first and, if the owner is under 59 and one half, carry an additional 10 percent penalty on the taxable portion. The penalty exceptions mirror those for annuities: the owner reaching 59 and one half, becoming disabled, or taking the money as part of a series of substantially equal periodic payments over life or life expectancy. Becoming disabled is therefore a qualifying circumstance for Fabien. Note that the exceptions relieve only the PENALTY. The distribution remains taxable as ordinary income to the extent of gain in every case.

An actuary explains that every contract the company issues must qualify as life insurance under Section 7702 by satisfying one of two alternative tests, and that the company applies a different test to its traditional whole life series than to its flexible premium universal life series. Which pairing correctly describes the two tests?

1. A.The cash value accumulation test, which limits cash value relative to the death benefit, or the guideline premium and corridor test, which caps cumulative premiums and requires a minimum death benefit corridorCorrect. Section 7702 gives two alternative qualification routes, and a contract need satisfy only one.
2. B.The cash value accumulation test and the guideline premium test, BOTH of which every contract must satisfyThey are alternatives. Requiring both would make the guideline premium route pointless.
3. C.The corridor test and the transfer for value test, either of which qualifies a contract as life insuranceThe transfer for value rule governs the taxability of proceeds after a policy is sold. It has nothing to do with qualification under Section 7702.
4. D.The 7-pay test and the guideline premium test, either of which qualifies a contract as life insuranceThe 7-pay test comes from Section 7702A and determines MEC status. It is not a Section 7702 qualification test.

Why: Section 7702 offers a contract two routes to qualify as life insurance. The CASH VALUE ACCUMULATION TEST limits cash value to the single premium that would fund the future benefits, and it is the natural fit for traditional fixed premium whole life, where the relationship between cash value and death benefit is built into the design. The alternative is the GUIDELINE PREMIUM AND CORRIDOR TEST, which caps cumulative premiums paid and separately requires the death benefit to stay above a stated multiple of cash value, the corridor. That two-part test suits flexible premium universal life, where the owner controls how much premium goes in. A contract needs to satisfy only one of the two.

Halvard owns an old whole life policy that is NOT a modified endowment contract and has 310,000 dollars of cash value. He exchanges it under Section 1035 for a new universal life policy with a modest death benefit, moving the entire 310,000 dollars in as a single lump sum. Regarding modified endowment status, what should his producer warn him about?

1. A.The new policy is tested afresh under the 7-pay test at the exchange, so a large lump sum against a modest death benefit can make it a MEC from inceptionCorrect. A 1035 exchange starts a new 7-pay test on the receiving contract, and a non-MEC can become a MEC.
2. B.The new policy inherits the old policy non-MEC status, so no 7-pay testing appliesNon-MEC status is not inherited. Only MEC status carries forward through an exchange.
3. C.MEC status is irrelevant because the exchange itself is tax free under Section 1035The 1035 exchange addresses gain recognition only. MEC status governs how future distributions and loans are taxed.
4. D.The 7-pay test cannot apply because the money came from an existing policy rather than from new premium dollarsAmounts received in a 1035 exchange count as premium paid into the new contract for 7-pay testing purposes.

Why: A Section 1035 exchange defers the gain, but it does not carry the old contract 7-pay history forward as a shield. The NEW contract is tested under the 7-pay test as of the exchange, using the new death benefit. Dumping 310,000 dollars into a policy with a modest death benefit will almost certainly exceed the cumulative net level 7-pay premium for that benefit, making the new contract a MEC from inception even though the old one never was. The remedy is to buy enough death benefit to support the premium, or to structure the transfer over time. The rule runs one way only: a policy that IS a MEC stays a MEC through an exchange, and a non-MEC can become one.