New Jersey Life Producer Practice Exam

What term describes a life insurance policy that fails to meet the seven-pay test?

1. Deferred policy

2. Modified endowment contract

3. Universal life policy

4. Term life policy

The correct answer is: Modified endowment contract

A life insurance policy that fails to meet the seven-pay test is classified as a modified endowment contract (MEC). The seven-pay test is a guideline established by the IRS to determine whether a policy will be treated as a MEC for tax purposes. If a policy accumulates cash value too quickly, exceeding the limits set by the seven-pay test, it will be categorized as a MEC. The significance of this classification is that, while MECs still provide life insurance coverage, they have different tax implications compared to traditional life insurance policies. Notably, withdrawals and loans taken against the cash value of a MEC are taxed on a last-in, first-out (LIFO) basis, meaning that any earnings in the policy are taxed before the principal. This can lead to unexpected tax liabilities for policyholders, which is why understanding the seven-pay test is crucial for those involved in life insurance planning. In contrast to a modified endowment contract, deferred policies, universal life policies, and term life policies do not hold the same tax status as MECs, and not all of them are designed in a way that makes them subject to the seven-pay test. Understanding this distinction is essential for producers and agents in advising clients on their life insurance options.