To counteract what was perceived as an abusive use of single-premium, limited-pay, and universal life policies as short-term tax-sheltered cash accumulation or savings vehicles, Congress passed legislation modifying Code section 7702, which provides the tax law definition of a life insurance contract, and creating Code section 7702A, which defines a new class of insurance contracts called modified endowment contracts (MECs).1

The basic difference between MECs and other life insurance contracts is the federal income tax treatment of amounts received during the insured’s life. Certain “distributions under the contract” that are not generally subject to tax when received from other life insurance contracts are subject to income tax and, in some cases, a 10-percent penalty when received from MECs.

In other respects, MECs are treated and taxed under the same rules that apply to other life insurance contracts that are not MECs. Basically, compared with policies that are not classified as MECs, MECs have detrimental tax consequences for some living benefits but the tax treatment of cash accumulations within the policy and death benefits is no different than for other policies.

What is a MEC? MECs are policies that meet the Section 7702 definition of life insurance and are funded more rapidly than a paid-up policy based on seven statutorily-defined level annual premiums. (See Appendix F for more information on Section 7702.)

The basic rules are:

1.     Policies “entered into” before June 21, 1988, are grandfathered from the MEC rules unless they undergo a “material” change.

2.     All policies entered into after June 20, 1988, and any policy, whenever issued, that undergoes a material change, must be tested under the MEC classification rules.

3.     Once a policy is classified as a MEC, it remains a MEC. A MEC will not change its MEC status if it is changed, adjusted, or reconfigured as a policy that would otherwise not be classified as a MEC.

4.     A policy received in exchange for a MEC is also a MEC, even if the policy that is received would otherwise not be classified as a MEC.


The tax treatment of certain amounts received from MECs prior to death — called distributions under the contract — is equivalent to the tax treatment afforded premature annuity distributions. To the extent of gain in the policy, such amounts are taxed on an income-first basis. In other words the first distributions out of the contract are not considered a tax free return of the policyowner’s cost but rather the investment earnings on the contract. Those earnings are deemed to be withdrawn, and therefore become taxable, before the policyowner can recover his or her tax free basis. So, only after all income or gain in the policy has been received are additional amounts treated as nontaxable return of the policyowner’s cost basis or investment in the contract.

In addition to the tax on distributions under the contract, a second tax is imposed in certain cases. This second tax is a 10-percent penalty tax. It is imposed on amounts received that are included in gross income.2

This 10-percent penalty tax does not apply to any distribution:

1.     made on or after a taxpayer attains age 59½ years of age, or

2.     attributable to a taxpayer’s becoming disabled, or

3.     which is part of a series of substantially equal periodic payments made for the life (or life expectancy) of the taxpayer or for the joint lives (or life expectancies) of the taxpayer and beneficiary.3

Generally, gain in the contract is determined by subtracting adjusted premiums paid from policy cash values. Adjusted premiums are total premiums paid (excluding premiums paid for supplementary benefits such as waiver of premium and accidental death benefit features) less any dividends received in cash or credited against premiums and less the nontaxable portion of any previous withdrawals. Cash value is computed without regard to surrender charges and so, for this purpose, is really the policy’s reserve or account value. Therefore, gain may exist and result in taxation of a distribution even though a policyowner cannot actually access it. Also, in some cases a full surrender could yield less tax than a partial withdrawal.

Amounts received that are treated as income-first distributions under the contract include:4

1.     policy loans (to pay premiums as well as for all other purposes);

2.     loans secured by the contract;

3.     interest accrued on a policy loan;

4.     withdrawals;

5.     cash dividends; and

6.     dividends retained by the insurer as principal or interest on a policy loan.

Amounts received that are not treated as income-first distributions under the contract include:5

1.     dividends retained by the insurer to pay premiums or other consideration for the contract;

2.     dividends used to purchase paid-up additions, term insurance, or other qualified additional benefits; and

3.     surrender of paid-up additions to pay premiums. However, it should be noted that the status of surrendering paid-up additions to pay premiums is uncertain. Most commentators feel they are not income-first distributions under the contract, but the issue has not yet been completely settled.

MEC tax treatment applies to amounts received during the contract year in which a policy effectively becomes a MEC as well as to amounts received in any subsequent contract year. It also applies to any distributions in the two years before the policy fails the seven-pay test.6

Example: Kathy purchased a life insurance contract on January 1, 1999. As of January 1, 2001, her basis in the policy is $100,000. The contract has a cash value of $140,000. The policy is a MEC. She borrows $50,000 from the policy’s cash value on her 50th birthday. Kathy’s taxable gain from the loan is $40,000 ($140,000 cash value – $100,000 basis in the policy). If Kathy is in the 28 percent income tax bracket, she must pay an income tax of $11,200 ($40,000 ’ 0.28). She must also pay a 10 percent penalty on the taxable amount. The penalty will be $4,000 ($40,000 ’ .10). Therefore Kathy’s total tax bill on the loan from the policy is $15,200 ($11,200 + $4,000). Note that all amounts included in Kathy’s gross income as a result of taking a loan from the policy will be added to her basis in the policy for purposes of determining future taxable amounts. Therefore Kathy’s basis in the policy after taking the loan will be $140,000 ($100,000 original basis + $40,000 taxable portion of loan). The $10,000 nontaxable portion does not affect Kathy’s basis in the contract because the transaction is a loan and not a withdrawal.


A MEC is a life insurance contract that meets the requirements of Code section 7702 and:

1.     was entered into on or after June 20, 1988, and fails to meet the seven-pay test, or

2.     is received in exchange for a MEC.7

A policy that originally satisfies the seven-pay test in its first seven contract years may nonetheless become a MEC if it undergoes certain material changes, which are described below. Policies that undergo material changes are subjected to a new seven-pay test.


The test for MEC status is called the “seven-pay” test. The seven-pay test must be applied in basically three situations:

1.     To initially test policies entered into after June 20, 1988;

2.     To retest policies entered into after June 20, 1988 if death benefits are reduced within the first seven contract years; and

3.     To test or retest any policy, even those entered into before June 21, 1988, when there is a material change in future benefits.


A contract fails to meet the seven-pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the “net level premiums” which would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of seven level annual premiums.8 Generally, “amount paid” is defined as the premiums paid under the contract reduced by any distributions but not including amounts includable in gross income. For purposes of this test, the death benefit for the first contract year is deemed to be provided until the maturity date without regard to any scheduled reduction after the first seven contract years. However, certain limited scheduled increases in death benefits may be taken into account.9

Example: If the annual net level premium for a $100,000 seven-pay policy is $4,500, then any $100,000 policy for the same insured on which aggregate premiums exceed $4,500 during the first year, $9,000 during the first 2 policy years, $13,500 during the first 3 policy years, $18,000 during the first 4 policy years, $22,500 during the first 5 policy years, $27,000 during the first 6 policy years, or $31,500 during the first seven years of the policy will be considered a modified endowment contract.

The seven-pay test does not require that a policy provide for seven level annual premiums to be paid over seven years. Rather, the test limits the cumulative amount that may be paid for each of the first seven years. Premiums may not be paid in advance in an amount that violates the annual premium limit. However, it is possible to make up for premiums paid in prior years that were less than the maximum amount permitted.

If the aggregate premiums paid during the first seven years are less than aggregate premiums that would have been paid on a level annual-premium basis using the net level premium amount ($4,500 a year in this example) for a seven-pay policy (for the same insured), the policy will not be a modified endowment contract and will receive the same tax treatment previously applicable to all policies.

Definition of Net Level Premium

The definition of a net level premium under these new rules is based on the guideline level premium concept under Code section 7702. The net level premium is not the same as the actual premium payable under the contract. It is also not the same as what many life insurance agents refer to as a net premium. “Net level premium” is a technical term of art that refers to an artificially constructed net level premium that is computed using mandated interest, mortality, and expense assumptions.10 Therefore, it is possible that even policies that require seven level annual premiums will not pass the seven-pay test in some cases because the artificial net level premium (as calculated under the regulations) will be less than the actual premium. In other words, if the net level premium is less than the actual premium payable, the payment of the actual premium due will cause the policy to fail the seven-pay test.

Actuarial studies show that the seven-pay test is generally quite generous in the amount of permitted premiums. For nonsmoker universal life policies under option A, the net level premium limits under the seven-pay test are higher than the guideline annual premium limits under Code section 7702 at all ages and for either sex. Under option B, the crossover age where the seven-pay test limits are more restrictive than the Section 7702 limits is in the mid-50’s for male nonsmokers and early 50’s for male smokers. For females, it is in the mid-60’s for nonsmokers and slightly earlier for smokers.11 All term insurance policies and virtually all guaranteed premium whole life policies without paid-up additions premium riders will meet the seven-pay test.

Riders to policies are considered part of the base insurance policy for purposes of the seven-pay test. Since the cost of such riders will be included in the calculation of the seven-pay test, a term rider may help a policy avoid classification as a MEC. Examples of such riders would be guaranteed insurability, family term, accidental death or disability, disability waiver, or other allowed benefits.

Contracts With Death Benefits Under $10,000

There is a variation on the application of the net level premium amount in the seven-pay test that applies to policies under $10,000 in face amount. For such policies, $75 a year can be added to the seven-pay-test premium.12 The $75 additional allowance permits some small seven-pay policies to pass the seven-pay test that otherwise might not. The smaller the policy is, the more likely it is that the actual premium will be less than the net level premium plus $75. The full $75 can be used for any amount of coverage between $1,000 and $10,000, resulting in a maximum allowable additional expense loading of $7.50 per $1,000 of coverage on a $10,000 policy.

Congress anticipated the added attractiveness of this small policy expense allowance and its potential abuses. Therefore the statute requires that all policies issued by the same insurer for the same policyowner be treated as one policy for purposes of determining that the face amount does not exceed $10,000.13 This prevents policyowners from purchasing a large number of small policies to take advantage of the allowable expense loading. Note that the statute does not require that policies from different insurers be aggregated for this purpose. This may present a planning opportunity for taxpayers purchasing several small policies from different insurance companies.

Refund of Excess Premiums

If the insurer returns premiums paid in excess of the net level annual premium limit plus the interest on the excess premiums within a 60-day grace period of the end of the contract year in which the excess occurs, the contract will not fail the seven-pay test. The returned amount will reduce the sum of premiums paid under the contract during such contract year for purposes of the seven-pay test. Interest paid will be includable in the gross income of the recipient.14


If death benefits are reduced within the seven-year testing period, there is a look-back requirement. The seven-pay test must be reapplied as if the contract originally had been issued for the reduced benefit amount.15

Example: Assume the guideline annual premium is $10,000 based on the original death benefit. The policyowner pays $9,000 each year for the first 6 years. In year seven, the policyowner withdraws $36,000, with a corresponding decrease in the death benefit. The recomputed guideline premium is $8,000. The policy now fails the seven-pay test and is a MEC since cumulative premiums paid in just the first year, $9,000, (and through year 6 as well) exceed the sum of the recomputed guideline annual premiums of $8,000. The $36,000 withdrawal will be subject to tax to the extent of gain in the policy. If the policyowner is under age 59½, a 10 percent penalty will also be imposed on the taxable portion of the distribution.

The seven-year rule for benefit reductions appears to apply only during the first seven contract years unless there is a material change. Therefore, absent a material change, a benefit reduction after the first seven years has no effect. A benefit reduction itself is not a material change. However, a material change may restart the seven-year look-back period for benefit reductions because a material change is treated like a new policy issuance. Apparently, benefit reductions within the first seven years after a material change will require a recomputation of the seven-pay test back to the date of the material change rather than the policy’s original issue date, even if the periods overlap.

Distributions Affected

If a policy fails the seven-pay test as a result of the look-back rule, certain distributions are treated as potentially taxable distributions from a MEC. These distributions include all future distributions, distributions in the contract year the policy is treated as failing the seven-pay test, and prior distributions taken in anticipation of failure of the test. The statute authorizes the IRS to promulgate regulations defining what are distributions taken in anticipation of failure of the test, but it specifically states that any distribution which is made within two years before the failure will be treated as made in anticipation of such failure.16

Reductions of Benefits Attributable to Nonpayment of Premiums

Any benefit reductions attributable to the nonpayment of premiums due are not taken into account if the benefits are reinstated within 90 days after being reduced.17 This rule applies to a nonforfeiture option of reduced paid-up insurance within the first seven contract years. In other words, if a policy that is put on reduced paid-up status fails the seven-pay test as a result of the look-back rule, the failure may be reversed if the policy is reinstated to its original death benefit within 90 days. Alternatively, failure of the test could probably be avoided by electing the extended term option rather than the reduced paid-up option. The policy could also be surrendered without adverse consequences since the complete surrender of a life insurance policy during the policy’s first seven years is generally not considered to cause the policy to be treated as a MEC.


Policies entered into prior to June 21, 1988, and policies entered into on or after that date with low enough premiums to avoid being classified as MECs are generally treated the same as life insurance policies have been treated in the past. This means there will generally be no income tax applicable to withdrawals until the policyowner’s cost basis has been recovered (tax free). This is the cost-recovery rule or first-in-first-out (FIFO) treatment long associated with life insurance policy taxation-18 Distributions or withdrawals that are subject to tax are not subject to the additional 10-percent penalty unless the policy is reclassified as a MEC.

However, a grandfathered policy or a policy that originally passed the seven-pay test when it was issued can become a MEC if there is a material change in the policy. A material change, in itself, does not cause a policy to become a MEC. A material change only subjects the policy to the seven-pay test. It is reclassified as a MEC only if it fails the test. For example, a single-premium life insurance policy acquired before June 21, 1988 is not a MEC. However, if there is a material change in the policy, it is subjected to the seven-pay test, which it would probably fail. It would then be a MEC.

Similarly, an elective increase in the death benefit (requiring evidence of insurability) of a universal life policy that was acquired before June 21, 1988 would also subject the policy to testing. However, depending on the timing and level of premium payments and the cash value in the policy, the policy after the change, in many cases, would pass the test. The policy would continue to be treated under the normal rules for life insurance contracts.

Changes That Are Not Material

What constitutes a material change under the law? What is not a material change is somewhat clearer than what is a material change, so the changes that are specifically excluded from consideration as material changes are addressed first. The statute provides the following specific exceptions to the material change rules:19

1.     cost-of-living increases in death benefits that are based on a broad-based index (such as the consumer price index) if such increase is funded ratably over the remaining life of the contract;

2.     increases in death benefits due to the premiums paid for the policy to support the first seven contract years’ level of benefits; and

3.     death benefit increases inherent in the policy design due to the crediting of interest or other earnings.

Exception (1) would be met by the standard cost-of-living rider where there is a level step-up of future annual premium charges for cost-of-living increases in death benefits. Exception (2) appears to exempt any increase in death benefits necessary to keep the required relationship between the death benefit and the policy guideline cash value or guideline premiums as specified in Code section 7702 from being classified as a material change. Exception (3) appears to exempt the increasing death benefits of an option II universal life policy or a variable life policy from being classified as a material change.

Also, certain changes will be treated as material, which, by inference, adds the following exceptions to the material change rules:20

1.     increases in death benefits, without limit, on policies which, as of June 21, 1988, required at least seven level annual premium payments and under which the policyowner continues to make at least seven level annual premium payments; and

2.     increases in death benefits (or the purchase of an additional qualified benefit after June 21, 1988) if the policyowner had a unilateral right under the contract to obtain such increase or addition without evidence of insurability.

The first exception means that level premium whole life policies entered into before June 21, 1988, are permanently grandfathered from the material change rules as related to increases in death benefits (but other material changes, such as an exchange, would make them subject to seven-pay testing). Universal life or other flexible-premium policies are, presumably, not included since they do not require the payment of level premiums. The second exception appears to be a “grace amount” or “safe harbor” for death benefit increases that the policyowner had a contractual right to obtain without evidence of insurability such as might be provided by guaranteed insurability riders.

Material Change Defined

The statute says “the term ’material change’ includes any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract.”21

Material Increases In Death Benefits

Any increase in death benefits under a policy (excluding the exceptions mentioned above) will be treated as a material change if:

1.     before June 21, 1988, the policyowner did not have a unilateral right under the contract to obtain such increase or addition without providing evidence of insurability;22 or

2.     the policyowner has a unilateral right under the contract to obtain increases or additions without evidence of insurability but such increases exceed the death benefit under the contract in effect on October 20, 1988, by more than $150,000;23

Basically, any increases in benefits that require evidence of insurability and even contractually-guaranteed increases that do not require evidence but that cumulatively exceed the amount in (2) will be treated as material changes. Shifting a universal life policy from death benefit option I to option II would be a material change since the election usually requires evidence of insurability.

On the other hand, increases without evidence of insurability may not be considered “material.” Examples of such “could be safe” contractual rights include increases pursuant to guaranteed insurability riders, guarantee issue offers, scheduled option II face amount increases, and Code section 7702 cash value corridor increases. Death benefit increases for grandfathered policies due to premium payments, reserve earnings, cash value corridor, and/or regular option II increases should not cause loss of grandfathering, even if over $150,000, because they are covered by the “necessary premium” exception to the material change rules.

Other Material Changes

The following other types of changes are also considered material:

1.     term life insurance conversions to permanent forms of coverage;24 and

2.     exchanges of one policy for another, whether or not tax free under Section 1035.25

It is uncertain whether changes in contract mortality charges or interest rate guarantees are material changes.

Seven-Pay Test As Applied To Material Changes

A material change in a contract’s benefits (or other terms) which was not reflected in any previous determination under the seven-pay test requires seven-pay testing. Apparently, a material change may take place anytime during the policy’s existence. When a material change occurs, the contract is treated as if it were a new contract entered into on the date when the change takes effect. The seven-pay test, as described above, is applied as of the date of the material change, not the issue date of the policy. In addition, the seven-pay test is adjusted by a “rollover” rule that takes account of the contract’s existing cash surrender value at the date of change.26

The procedure is as follows:

1.     Determine the seven-pay premium (based on the insured’s then attained age) for each of the next seven contract years after the material change.

2.     Multiply (a) the cash surrender value as of the date of the material change (determined without regard to any increase in the cash surrender value that is attributable to the amount of premium that is not necessary) by (b) a specified fraction. The fraction is the ratio of:

a. the seven-pay premium for the future benefits under the contract after the change to

b. the net single premium for such benefits computed using the same assumptions used in determining the seven-pay premium.

3.     Subtract the product of the multiplication in step (2) from the amount determined in step (1).

The remainder is the adjusted seven-pay premium used to test actual premiums paid in each of the next seven contract years.

The adjusted seven-pay premium so determined could be negative if the cash value is large enough. This should not automatically make the contract a MEC. However, payment of additional premiums in the next seven years might make the policy a MEC.