What happens if a life insurance policy fails the 7-pay test?

If a life insurance policy fails the 7-pay test, it is classified as a modified endowment contract (MEC). This designation results in less favorable tax treatment; specifically, any withdrawals or loans taken from the policy are subject to income tax to the extent of gains, and a 10% penalty may apply if taken before age 59½. Additionally, MECs lose some of the tax advantages typically associated with life insurance, such as tax-free growth of cash value.