CARD Q060
Why does failure of the seven-pay test matter for a life insurance contract?
- The death benefit becomes fully taxable as ordinary income
- All policy distributions become taxable even when no gain exists
- Withdrawals become basis-first while loans remain untaxed
- It can become a modified endowment contract (MEC), changing distribution tax rules
It can become a modified endowment contract (MEC), changing distribution tax rules
A modified endowment contract (MEC) is life insurance with different tax rules for withdrawals and loans, usually because it was funded too quickly. It remains life insurance.
Why each choice is right or wrong
A. The death benefit becomes fully taxable as ordinary income
Incorrect. MEC status does not generally remove the death-benefit exclusion.
B. All policy distributions become taxable even when no gain exists
Incorrect. Taxation generally reaches gain, not every dollar when no gain exists.
C. Withdrawals become basis-first while loans remain untaxed
Incorrect. MEC treatment generally reverses this claim: gain-first distributions and loans treated as distributions.
D. It can become a modified endowment contract (MEC), changing distribution tax rules
Correct. A modified endowment contract (MEC) is life insurance with different tax rules for withdrawals and loans, usually because it was funded too quickly. It remains life insurance.
Review the related terms
Use these lessons to revisit the concepts and try additional practice questions.