What is a 7-pay premium life insurance, have you ever heard of it? In common, life insurance with a term installment period only offers three times of annual premium periods. The insurance policy usually offers it in 10, 20, or 30 years installment. If it is more than that, it is called whole life, permanent life, or universal life insurance.
Meanwhile, the life insurance with over 7 annual premium payments is under 10 years. The policyholder merely has seven years to pay off the installment. It has an almost similar definition and benefits to the other limited payment life insurance. It can be used for income replacement, death benefits, medical expenses, and other daily expenses. The insurer also should pay the funds to the beneficiaries when the policyholder dies during the term.
Term Life Insurance Under 10-Years Installment Is A Test
It can be said the 7-pay installment life insurance includes the 10-pay premium life insurance. The term policy is such as a test to make sure life insurance remains life insurance. It implies the 7-pay premium life insurance cannot receive a premium larger to paid up after seven years. The test can belong to the benchmarks of the policyholder’s capability.
The insurance policy gives the seven-year test as a probation period. A lot of policyholders fail to pass the test which makes them lose their status as a life insurance contract. Then, the contract changes into a Modified Endowment Contract (MEC). Surely, the failure and reclassification affected the change of several tax aspects of the insurance contracts.
By undergoing the 7-pay test premium installment, the policyholder can be avoided to buy the life insurance as a tax shelter excessively. Then, the policyholder makes a large initial payment of premium into the policy intentionally. The 7-pay test also prevents the creation of a new set of rules about the taxes when a lot of money flows into a life insurance contract.
What Happens If The Seven Pay Life Insurance Change Into MEC?
MEC or Modified Endowment Contract is a tax qualification. It derives from a life insurance policy with funding that exceeds federal tax law limits. The MEC changes IRS policy classification and the tax structure permanently after the life insurance policy changes.
The MEC itself still has a limit for the policy depending on the death benefit amount and the term. Besides the 7-pay test or 7-pay premium life insurance, IRS considers the life insurance as MEC based on two other criteria:
- Life insurance life ruled since June 20, 1988
- It must meet the definition of a life insurance policy statutory.
So, there are three criteria for a life insurance change into MEC besides the failure of the life insurance policy to meet the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) 7-pay test.
Does MEC Ask For Paying Tax On The Policy Holder’s Cash Value?
MEC does not make the insured owe tax on the cash value immediately. The policyholders even still can enjoy the tax-deferred cash value growth. Thus, MEC continues to be tax-free for the cash accumulation as long as it remains inside the policy.
However, there are very important changes to figure out to the tax rule in the Modified Endowment Contract. They are such as below:
- The money distributed from the policy becomes taxable if there is a profit inside the policy. If you have changed into MEC because of the 7-pay premium life insurance test violation, you will get an income tax liability. The tax liability is ruled when you take the policy loan against your cash value. You also will get tax income toward the balance of the loan if you have a policy loan outstanding.
- MEC changes into follow LIFO because it has lost life insurance’s FIFO accounting rule. FIFO is the First-In-First-Out accounting principle that your cost basis in dollars must come first. You can take your life insurance fund without paying taxes again if you pay the premiums with post-tax dollars.
Meanwhile, LIFO is an alternative accounting principle requiring the policyholders to take out the last dollars first. It implies LIFO (Last-in First-Out) has gained on the funds creating a tax liability.
- The MEC asks for a 10% penalty tax when it is distributed before age 59.5. It is similar to early Traditional IRA and qualified account distributions.
- A loan with MEC as collateral creates “distribution” from MEC as all tax consequences as a policy loan or withdrawal.
Does The 7-Pay Test Just Take Place For 7 Years?
People assume the 7-pay test life insurance just takes place in 7 years makes sense. But, it is sadly not as a seven-year timeline can be reset each time the policy gets a material change. The material change of life insurance is defined by IRS as a qualified benefit addition or a death benefit increase.
At the time the material change occurs, the 7-pay premium life insurance test timeline resets. Alongside that, a new maximum premium is calculated as the MEC compliance for the next seven years.
Pros And Cons MEC As The Result Of Life Insurance Change
In general, changing a life insurance policy to a MEC is a not good case. It is because MEC has lost a lot of tax advantages as life insurance when it is classified. Even, it can create an estate planning tool in the current circumstances if purposefully covert to MEC.
Does there any pros and cons of MEC to know? Commonly, the policyholder does not want to change their term life insurance into MEC. Moreover, MEC always makes the tax advantages inside the life insurance policy disappear. Besides that, the money inside the MEC is far less accessible than the life insurance policy.
Some sources say several individuals may get benefits from purchasing MEC but the reality it is not for life insurance. Hence, it is because they often offer higher results on effectively riskless money. Besides that, the insurance policy allows transferring the funds to the beneficiaries without tax and probate from the owner’s death.
Can The Policy Holders Avoid MEC?
Of course, the policyholder can avoid MEC in their life insurance program. The most important thing is the insured never pay the installment based on the required corridor below the death benefit. You do not need to pay off your 7-pay premium life insurance before the seven years. If you want to use a policy to accumulate cash value, you can raise the corridor’s ceiling through paid-up additions (PUA).
Benefits Of Life Insurance That You Might Forget
Up to now, some people still doubt joining the life insurance policy both permanent and term. Moreover, the fund payment sounds unclear and it tends to lose all money when the policyholder is still alive after the insurance expired.
However, death is a mystery and it often leaves a deep sadness for the heirs primarily the spouse and the children. Worse, sudden deaths such as accidents can also cause economic hardship. Therefore, there is nothing wrong with trying to buy an insurance policy such as the 7-pay premium life insurance at the beginning. This term of life insurance gives a cheaper premium cost to pay. You can pay it monthly, quarterly, semi-annual, or yearly during the seven years based on your contract.
If you are also hesitant to buy the life insurance, you may learn some benefits below to consider:
- Income replacement
The life insurance policy paid by the insurer can be the income replacement for the beneficiaries. They can use it to replace their lost income during caring for the insured before dying during the term period. It is normal when the children should lose of salary as they must resign from their job to take care of their parents.
- Paying off a home mortgage
People as the death benefit receiver allow using the fund to pay off their home mortgage.
- Paying off other debts
Life is full of debt where almost all people have it to meet their needs including their families. Therefore, the life insurance policy is useful to pay off student loans, car loans, credit loans, and many more.
- Providing kid’s funds for college education
Kids need funds to pay for their education in the future. The life insurance policy paid to the beneficiaries is useful for their college education fees.
- Helping other obligation
It will help with other obligations like caring for aging parents.
Beyond those points and your coverage amount, the life insurance policy also provides other benefits such as below:
- Tax advantages of life insurance
The policyholder will get some tax benefits inside the life insurance. It is because the death benefits payouts are tax-free. Some policies also have features to help transfer money with fewer tax liabilities to heirs.
- Cash value accumulation
Some policies give cash value that accumulates over time to pay premiums later. It can be used to help live on in retirement.
- Bundled to other types of insurance
It turns out the life insurance policy can be joined to other types of protections. For instance, you bundle your term life insurance with disability insurance. The benefit is it will help you replace a portion of your income if you cannot work again.
- Helps the rider’s accident care
Many life insurance policies give a valuable contract to the “riders”. They might allow the use of some portion of funds to pay for their accident treatment before death.
What do you get from the term-life insurance such as the 7 annual installments type? The term life insurance both over seven years and more gives additional benefits such as below:
- The typically lower premium cost
It is different from the whole life insurance, the term life insurance has a lower premium cost. It implies you can suit your financial condition to pay the installment without getting the risk of violation.
- Simple to figure out
The term life insurance policy has an easier definition and guide to understand. You quite choose one of the life insurance agents and they will make you figure it out.
- Flexible to change
The fact is that term life insurance is flexible to change to permanent life insurance. You can also move from the seven-year to ten or more annual installment type when your life insurance ends or expired.
- No penalty
Lastly, the policyholder can leave or stop paying the premium without getting a penalty. However, they just lose the premiums already paid.
The Bottom Line
The 7-paid premium life insurance is a 7-pay test to prevent the policyholders trapped in MEC. If the policyholders fail the test and convert into MEC, it means they do not have the life insurance contract again. They should avoid MEC by understanding the information in the article. It will help them to save their heirs when they die and are still in the life insurance contract time. Find out the benefits of the common and term life insurance too here to convince your intention. Good luck!