How does the 7-pay test work?

The 7-pay test is a regulation used by the IRS to determine if a life insurance policy is classified as a modified endowment contract (MEC). Under this test, the total premiums paid within the first seven years of the policy cannot exceed the total amount of premiums that would have been paid under a seven-pay whole life policy. If the premiums exceed this threshold, the policy becomes a MEC, which alters the tax treatment of withdrawals and loans from the policy, making them subject to income tax and potential penalties. This test helps ensure that the primary purpose of the policy is life insurance rather than a tax-advantaged investment vehicle.