Final answer:
If a life policy does not pass the 7-pay test, it becomes a Modified Endowment Contract (MEC). This changes the tax treatment of distributions from the policy, potentially incurring income taxes and a 10% federal tax penalty if under age 59 1/2. Policyholders should seek advice to understand the implications of a MEC.
Step-by-step explanation:
If a life policy does not pass the 7-pay test, that policy gets classified as a Modified Endowment Contract (MEC). This has important tax implications for the policyholder. The 7-pay test is a rule established by the Internal Revenue Service to prevent people from taking advantage of the tax-free benefits associated with life insurance. A policy that fails this test has exceeded the amount of premium payments that can be paid within the first seven years in order for the policy to be treated as life insurance for tax purposes.
When a policy is classified as a MEC, cash withdrawals or policy loans taken out are subject to a different tax treatment than a standard life insurance policy. Specifically, distributions from a MEC are taxable from the outset, and gains are taxed on a last-in-first-out (LIFO) basis. Furthermore, if the policyholder is under the age of 59 1/2, these taxable distributions may also be subject to a 10% federal tax penalty.
It is important for policyholders to consult with their tax advisor or financial planner to understand the implications of a policy becoming a MEC and to avoid accidentally triggering MEC status unless it aligns with their financial objectives.