Tennessee Insurance Practice Exam

According to IRS guidelines, which policy type is often deemed overfunded?

1. Whole life insurance

2. Universal life insurance

3. Modified Endowment Contract

4. Term life insurance

The correct answer is: Modified Endowment Contract

A Modified Endowment Contract (MEC) is considered overfunded according to IRS guidelines because it exceeds the limits set for premium contributions relative to the death benefit provided. When a life insurance policy is funded excessively, it affects the tax treatment of the policy's cash value. The IRS has established a test known as the "7-pay test," which limits the total amount of premiums that can be paid into a policy within the first seven years to maintain its tax-advantaged status. If a policy fails this test, it is classified as a MEC. Once a policy is designated as a MEC, any withdrawals or loans taken against the cash value are taxed more stringently, similar to non-qualified accounts, meaning that gains are taxed as ordinary income. In contrast, other types of life insurance, such as whole life, universal life, and term life, do not inherently have the same structure related to funding limits and tax implications when it comes to withdrawals and loans. Whole and universal life policies can accumulate cash value, but they can typically be structured to remain within the IRS guidelines without hitting MEC status, as long as premiums and cash value growth are managed correctly. Term life insurance, on the other hand, does not build cash value at all and