What must happen for a policy to be classified as a Modified Endowment Contract?

For a life insurance policy to be classified as a Modified Endowment Contract (MEC), it must fail the seven-pay test. The seven-pay test assesses whether the cumulative premiums paid into a policy during the first seven years exceed the sum of the net level premiums that would have been paid on a policy that provided paid-up benefits after seven years. If the premiums exceed this threshold, the policy is considered a MEC.

Policies classified as MECs face different taxation rules, specifically regarding the tax treatment of distributions and loans, which can lead to tax implications for the policyholder when money is taken out. This classification aims to prevent consumers from using life insurance primarily as a tax shelter by funding the policy too heavily in the early years.