Modified Endowment Contract: 7-Pay Test, Taxes, 27 Insurers

The rule, in the words of the statute

Section 7702A is short. It applies to “any contract meeting the requirements of section 7702”, so a MEC is a life insurance contract, not a different product. Ten provisions decide whether yours is one and what it costs.

Source: 26 U.S. Code, Cornell Legal Information Institute, read on October 19, 2026.

The 7-pay test with numbers

The statute gives the test but not the premium: the “7-pay premium” is a net level premium the insurer computes from the policy's benefits, the insured's age and class, and the mortality and interest assumptions of Section 7702. It is on your policy illustration or annual statement. The only worked example from the IRS is in Rev. Proc. 2008-39, where a policyholder pays $10,000 and then $10,750, $10,800, $10,700, $11,500, $11,000 and $10,000 against a 7-pay premium of $10,490 a year, and the insurer fails to return the excess:

Source: Rev. Proc. 2008-39, section 5.03(3)(a), Internal Revenue Bulletin 2008-29 (July 21, 2008). The overage column is the IRS's own; we confirmed it as paid minus 7-pay.

The IRS's policyholder starts under the limit and crosses it in year 3, by $80, because his later payments (several above $10,490) caught up with the cumulative 7-pay premium. An overage of $80 counts; the statute has no tolerance.

Now a hypothetical for a larger premium. Assume the insurer's 7-pay premium is $50,000 a year:

Our arithmetic on a hypothetical 7-pay premium of $50,000. The $300,000 is over the limit for the first five years, and the test is failed the moment it is exceeded once. A year-1 premium of $150,000 would be $100,000 over the year-1 limit, and the policy stays out of MEC status only if $100,000 is returned within 60 days after the end of contract year 1.

What a MEC costs when you take money out

For a policy that is not a MEC, Section 72(e)(5)(A) provides that the income-first rule and the loan rule “shall not apply”, so a loan is not income and a withdrawal comes first from your premiums (investment in the contract). For a MEC, Section 72(e)(10) turns on the income-first rule and treats a loan or pledge as money received. Take a policy with $1,000,000 of cash value and $600,000 of premiums paid, so $400,000 of income:

Our arithmetic from Sections 72(e)(2)(B), 72(e)(3), 72(e)(4)(A), 72(e)(10) and 72(v)(1). A withdrawal from a policy that is not a MEC is not income until it exceeds premiums paid; the loan column shows the stricter point that a loan from a policy that is not a MEC is not a distribution at all. Section 72(e)(4)(A) increases the investment in the contract by the amount taxed on a MEC loan (our reading).

Two further rules widen the net. A distribution “made within 2 years before the failure to meet the 7-pay test shall be treated as made in anticipation of such failure”, so a withdrawal that looked free can become taxable if you later overfund. And “all modified endowment contracts issued by the same company to the same policyholder during any calendar year shall be treated as 1 modified endowment contract”, so splitting a premium across two policies in one year does not split the income.

The 60-day window, and what 27 insurers say they do

Section 7702A(e)(1)(B) is the cure: premium returned with interest “within 60 days after the end of such contract year” is deemed not paid. The statute does not require the insurer to warn you. Whether your premium is returned before the year ends depends on the insurer's own procedure, which the SEC makes it describe in the prospectus. We searched EDGAR full text for the phrase “modified endowment contract” in Form 485BPOS and N-6 filings from October 1, 2025 to October 19, 2026, downloaded the main document of each of 72 registrants (our search script capped at the first 400 results) and kept the sentence in 27 of them that says what the insurer does with a premium that would cause MEC status.

Source: 27 prospectuses on SEC EDGAR filed from April 9, 2026 to June 30, 2026 (accessions in the table below and in the data file). Grouping is our reading of the quoted sentence; the full prospectus may say more. Principal and Penn Mutual wording is quoted because each is hedged.

The sentences themselves, verbatim:

Time limits stated in the same documents differ as much as the defaults. Pacific Life says it will return the premium “no later than 60 days after the end of the Policy Year”, John Hancock “in no case more than two weeks after receipt”, and AUL gives the owner “one hundred sixty (160) days after receiving such notification to request the refund”. The statute counts 60 days from the end of the contract year; ask your insurer which date it applies to your premium and when it will treat the 60 days as running.

Across all 72 prospectuses we read, 64 contain text linking a 10% figure to a penalty or additional tax, 43 mention age 59½, 47 mention the seven-pay or 7-pay test and 11 state a window of 60 days after the end of the policy, contract or certificate year (our regular-expression count; the file lists each document).

After the 60 days: the IRS closing agreement

If the window passes, the policy is a MEC for the life of the contract. RiverSource's prospectus says so (“your policy will remain a modified endowment contract for the life of the policy”), Commonwealth Annuity says the policy “will be classified permanently” as one, and Lincoln Benefit says a policy issued in exchange for a MEC from another insurer is itself a MEC, which matches Section 7702A(a)(2). There is one IRS mechanism. Rev. Proc. 2008-39, effective July 21, 2008, lets an issuer “remedy an inadvertent non-egregious failure to comply with the modified endowment contract rules”. It works like this:

Source: Rev. Proc. 2008-39, Internal Revenue Bulletin 2008-29. The model closing agreement is in section 6.

For a policyholder the practical points are three: the application is made by the insurer, not by you; it requires that the failure be inadvertent, which a deliberately overfunded policy is not; and the insurer's payment is computed with a flat applicable percentage of 15%, 28% or 36% chosen by death benefit, so the holder's own tax rate does not enter. The agreement is silent on what the insurer owes you: it creates no liability of the issuer to the holders.

MEC status and private placement life insurance

For a private placement life insurance policy, MEC status is a design choice rather than an accident. A policy funded in one or a few large premiums is a MEC almost by definition, and the buyer gives up tax-free policy loans in exchange for leaving the money to compound until death. We cover the other tests a PPLI policy must pass (Section 7702, the diversification rules of Section 817(h) and the investor control doctrine), the Senate Finance Committee data and S. 4279 in our PPLI guide. For a wealthy holder the two estate-planning pages that usually sit next to this one are the estate tax exemption and the annual gift tax exclusion.

What a holder can do with this

• Find your 7-pay premium. It is on the policy illustration or annual statement. Compare it with cumulative premiums paid, year by year, as in the Rev. Proc. table above.
• Read the premium section of your prospectus before paying a large premium. Search it for “modified endowment”. The sentence tells you whether the insurer returns the premium, notifies you, or processes it. The census above shows all three.
• If you get a notice, note the date of the end of the contract year, not only the date of the notice. The statute's 60 days run from the contract year end.
• Before a withdrawal or loan, ask in writing whether the policy is a MEC and whether any premium, benefit reduction or death benefit increase in the last 7 years could have changed that. A distribution made in the 2 years before a failure is treated as made in anticipation of it.
• Before cutting the death benefit or adding riders within 7 years, ask for a new 7-pay calculation. A reduction or a material change re-tests the policy.
• If it is already a MEC, price the exits. Loans and withdrawals are taxed gain first; ask what leaving the money in, a surrender, or a Section 1035 exchange to a new policy (which would itself be a MEC) would cost on your numbers.

FAQ

Sources, read and saved on October 19, 2026: 26 U.S. Code Sections 72, 101 and 7702A (Cornell Legal Information Institute); Rev. Proc. 2008-39, Internal Revenue Bulletin 2008-29 (July 21, 2008, irs.gov); the main documents of 72 SEC Form 485BPOS and N-6 filings by life insurer separate accounts filed from October 1, 2025 to October 19, 2026, found by EDGAR full-text search, of which the 27 quoted are saved in full with the search and download scripts and a per-document index. Counts, ratios, the 7-pay illustration and the loan tax examples are our arithmetic or our reading, and the grouping of insurer sentences is our classification. This is analysis of public documents, not investment, legal or tax advice.