In relation to the seven-pay test, a Modified Endowment Contract that does not pass the test results in taxes on distributions taken prior to death.

• A. Distributions are not taxed
• B. Distributions are typically taxable
• C. Distributions are exempt if policy surrender
• D. There is a 0% tax on distributions

Answer: (B)

The seven-pay test controls how quickly a life insurance policy’s cash value can accumulate in a way that remains favorable for tax purposes. If the policy fails this test, it becomes a Modified Endowment Contract (MEC). Once a policy is a MEC, any distributions taken before death—whether you withdraw cash or borrow and treat that loan as a distribution—are taxed as ordinary income to the extent of the policy’s gains. The portion of the distribution that comes from the premiums you paid (the basis) is returned tax-free, but the gains portion is taxable. Because distributions typically include some amount that represents earnings, they are generally taxable under this rule. The death benefit itself remains generally income-tax-free to beneficiaries, but predeath distributions from a MEC are taxed as described.