7 pay test explained for life insurance

If this policy that you were, was illustrated to be paid for, let's just say 45 years, was only paid for seven years, this is the maximum amount of premium that could be paid into. Now, something that we do for our clients is, you know, year three could come around and we'll, we'll go to the company and say, what's the max contribution we can put into this policy. And what's cool is these companies will run a new MEC test to see, you know, based on what you want to, what you want to contribute or what is available to contribute, it won't cause a MEC. This is BetterWealth with Caleb Williams. Hey everybody. Welcome back to another episode of BetterWealth Breakdown. On today's episode, we're going to be talking about the seven pay test. And last week we talked about the MEC and this very much is a part two, but a MEC stands for a modified endowment contract. And when you MEC a policy, it becomes taxable. And so really the secret sauce, if you want to reap all the benefits of tax-free benefits of the life insurance, you want to go right up to the MEC line. And we have an episode that we break all that down. Something that comes up frequently is when people look at their illustrations, they see this thing called seven pay test. We just told them that we're optimizing their policy. They're saying, Hey, the seven pay tests in my contracts is I can put a lot more. And so hopefully this can help educate, but then also help clarify this for future, future clients. Well, yeah, this is one of those cases where it's, it's, it's clear as mud. I think, I think most life insurance agents are confused about this, let alone people that are getting policies like this and reading the contracting. I got my handy dandy notes here. And this actually comes from directly from a policy that we have in house. And what's interesting is if you listen to our last episode, there's this talk about the current understanding of the modified endowment contract. But I just want to paint the picture here. This is a $25,000 annual policy. And it's, you know, the gentleman is 30 years old and he's going to pay it until he's a hundred or something like that. And he has the option. He has the option. He has the option too, but he's going to want to mathematically. Uh, so what's interesting is he actually came to us and said, wait a minute. My, my policy says it's $25,000 annual premium, but on the seven pay test, it says, you know, the, the max is 35,166. I thought you guys are optimizing this policy to be as efficient as possible. And it's like, okay, uh, let's, let's break this down as to what, what does the seven pay test mean? And so this actually comes from the technical and miscellaneous revenue act of 1988 Tamra seven pay test. And again, we talked about a little bit about this in the last episode. Uh, but in 1988, uh, they basically enacted this rule that you, you can't pay too much for life insurance. Otherwise it becomes a modified endowment contract. And one of the main things that they use is what's called the seven pay test. So to, to explain what that is. And this is again, straight verbiage that is going to be a little confusing and we'll break it down. It says the seven pay test determines whether the total amount of premiums paid into a life insurance policy within the first seven years is more than what was required to have the policy considered paid up seven years policies become max when the premiums paid to the policy are more than what was needed to be paid within the seven year timeframe. And so when we read this verbiage, the second, um, line item here says based on our current understanding of current tax laws, this policy as illustrated is not a modified endowment contract. And what this $35,000 number is coming from is basically saying that if, if you were going to squeeze everything together and you were going to stop paying premiums and do what's called reduced paid up, which eliminates riders and, and reduces the death benefit, the $35,000 is the maximum amount of money that you could pay into this policy before it became a modified endowment contract. And where this can become tricky is if you, something happens and you can't, pay your premiums and there, there were certain fail safes weren't in place to make sure that it could survive by itself and you had to try and reduce pay up the policy. It could be, could happen where let's say it was a million dollar death benefit and you go to reduce, pay it up. It's going to reduce the death benefit because you're not continuing to pay into the policy. And if you've been paying dutifully into the policy, you could, when the, when the MEC test, the seven pay recalculates, let's just say the reduced paid up, brought it down by half. So your death benefit is now 500,000. Yeah. And you've been paying dutifully $25,000 a year into the, the calculation would most likely say that you've been paying too much premium into the policy and would cause it to MEC. Let's, let's talk about the reduced paid up because this is something that we don't talk a lot about because you, you mentioned early on, if you understand this and how it works, you never want to stop paying because if you understand cashflow, if you understand this assets, giving your ability to give your dollars multiple jobs, it never makes sense. It doesn't make sense to just stop. But understanding that you don't have to pay a policy for the rest of your life is beneficial. What a reduced paid up pretty much says is you don't have, if you enact that, you're not on the hook to pay any premium and your cash value will continue to grow, but what they'll do is they will take your death benefit and reduce it. And then it will slowly grow and it will obviously be less efficient because you're not adding to it, but it'll still, it'll still, it still could be a good thing. And what the seven pay test is pretty much saying is assuming you like, it's pretty much a technicality to say, we understand a MEC to be that if you overfund and reduce pay up in seven years and you overfunded what that, that number and every number is different depending on who you are, what situation you're in, it's considered a MEC. So it's really the insurance company doing, it's their way of, of reading the tax law to make sure that they're in balance. And each company has a little bit different interpretation of the seven, seven pay tests. Is that correct? Yeah. I think the easiest way to explain this is, is all of what I said is probably really confusing. And, and the gist of it is if this policy that you were, was illustrated to be paid for, let's just say 45 years, right. Was only paid for seven years. This is the maximum amount of premium that could be paid into. Now, something that we do for our clients is, you know, year three could come around and we'll, we'll go to the company and say, what's the max contribution we can put into this policy. And what's cool is these companies will run a new MEC test to see, you know, based on what you want to, what you want to contribute or what is available to contribute, it won't cause a MEC. And so there's a lot of opportunity here to, to potentially pay more money. And even though we are making these as efficient as possible, it's, it goes back into, there's a lot of variables here. The rules might change. Like we discussed in last, last episode, the dividend might change, the mortality costs might change, which all of these things and, and then their interpretation of the MEC guidelines may allow you to pay more premium into the policy. That's right. And so this is, it's just kind of a value add that we, we do for our clients is to do that max contribution. But the overarching thing here is this is, this is not saying that this gentleman could pay this in every single year for the whole policy. It's saying that if we were to stop payments at year seven, this is the max that you could pay into it. Yeah. And we're, we're giving them in this situation an ability to pay a lot longer than seven years. And so this person is way better off doing the initial plan, but I guess if this person wanted to just do seven years and reduce pay up, technically speaking, he could overfund for seven years. And if nothing changes, it's, it would be tax free. Right. And something else I've seen is even past the seven years, if you want to reduce pay up and you've been really heavily overfunding a policy, it, it may have to continue on at just the base premium for a couple more years to prevent it from becoming a MEC. Again, this, this is because we've been paying so much in, and then we're reducing the face value or the death benefit of the policy, and you've paid so much premium in it, it could cause it to become a MEC in its own right. And so there's, there's a lot of variables that come into play with this. And these, this happens sometimes in people that they, they only want to pay like 12 years or 15 years or, or kind of reduce a, a long pay policy down to an unlimited amount of time. And you can actually illustrate it and see, and more often than not, especially when these policies are over overfunded, that that's what happens. And it's, it's not the end of the world because we can land the plane in a lot of different aspects. Um, but it's the seven pay test or the MEC test is not, um, just in the first seven years, that's the thing, the distinction, but in the context of the seven pay, again, I just want to really highlight that this is, if we were going to stop paying premiums in seven years, this max amount of premium. So for the listener, because we have people that are very technical that have been asking for stuff like this, but we also have people that are like, Hey, I, I get the full picture. I want to work with someone like you guys who get, get it, but I don't necessarily need to understand the seven pay test. What is the key takeaway and the purpose of this episode? Well, the key takeaway is that we in fact are optimally designing these. Um, and, and I, I take that to heart because I, I, I say it as we design these in the way that if they were our own, and that goes back to much like we talked about in the last episode of first, we get clear on what result we're after, because that determines a lot of different variables. Um, but the, the thing to the takeaway here is that the seven pay is not saying that this is the max amount of premium you can pay every single year. It's, it's not saying that your policy is inefficient. Uh, it's simply stating what we've already gone through. I love it. Live intentionally. I hope you enjoy this. Uh, if you have any questions, feel free to email me at Caleb at better wealth.com. And we are like very open to getting your feedback. We're, we're doing these episodes because there, there was a demand there were requests and we're like, if anytime someone asks us a question, we get it more than once, we're like, why don't we use this podcast as a way to record the answer and then have it where we can scale and go back to it in the archives and send it to people. So I hope that this is, this is helpful. You can expect to get some more technical from this channel, but also you can also expect to get some bigger picture on where you should be going and how you should be living as it relates to your money and how you view everything. So anyways, take care, be well, we'll see you tomorrow. Thank you so much for listening to the better world podcast. It would mean the world to me if you could hit subscribe, leave a review and share this with the people that you know and love.