Colorado Life Producer License Practice Test

A policy that accumulates excessive cash value within the first seven years is at risk of being classified as?

1. Term Insurance

2. Modified Endowment Contract

3. Universal Life

4. Whole Life

The correct answer is: Modified Endowment Contract

A policy that accumulates excessive cash value within the first seven years is at risk of being classified as a Modified Endowment Contract (MEC). The MEC designation is determined by the IRS and it applies to whole life and universal life insurance policies that fail to meet the seven-pay test. This test ensures that the total premiums paid into the policy in the first seven years do not exceed the sum of the seven annual premiums allowed for a paid-up policy. If a policy exceeds this limit, it is classified as a MEC. The importance of this classification lies in the tax implications. Policies classified as MECs lose the favorable tax treatment typically afforded to life insurance. Specifically, the tax-deferred growth on the cash value is still maintained, but any withdrawals or loans taken from the cash value after the policy is classified as a MEC may be subject to income tax, and if the policyholder is under 59½, a 10% penalty may apply. This classification helps regulate policies that could be seen as a tax-advantaged investment rather than life insurance, ensuring that the primary purpose of the policy remains protection for the insured's beneficiaries. Understanding the MEC rules is crucial for producers so they can advise clients on the implications of their chosen life insurance products.