For Single Insured
For contracts insuring a single insured, if death benefits are reduced within the seven-year testing period, there is a look-back requirement. The seven-pay test must be reapplied as if the contract originally had been issued for the reduced benefit amount.
Example. Assume the guideline annual premium is $10,000 based on the original death benefit. The policyowner pays $9,000 each year for the first six years. In year seven, the policyowner withdraws $36,000, with a corresponding decrease in the death benefit. The recomputed guideline premium is $8,000. The policy now fails the seven-pay test and is a MEC since cumulative premiums paid in just the first year, $9,000, (and through year six as well) exceed the sum of the recomputed guideline annual premiums of $8,000. The $36,000 withdrawal will be subject to tax to the extent of gain in the policy. If the policyowner is under age 59½, a 10 percent penalty will also be imposed on the taxable portion of the distribution.
The seven-year rule for benefit reductions for contracts insuring a single insured appears to apply only during the first seven contract years unless there is a material change. Therefore, absent a material change, a benefit reduction after the first seven years has no effect. A benefit reduction itself is not a material change. However, a material change may restart the seven-year look-back period for benefit reductions because a material change is treated like a new policy issuance. Apparently, benefit reductions within the first seven years after a material change will require a recomputation of the seven-pay test back to the date of the material change rather than the policy’s original issue date, even if the periods overlap.
For Joint Life or Second-To-Die Contracts
A death benefit reduction at any time, not just during the first seven contract years, for a joint life, survivorship life, or second-to-die contract results in section 7702A retesting. The seven-pay test must be reapplied as if the second-to-die contract originally had been issued for the reduced death benefit amount.
If a policy fails the seven-pay test as a result of the look-back rule, certain distributions are treated as potentially taxable distributions from a MEC. These distributions include all future distributions, distributions in the contract year the policy is treated as failing the seven-pay test, and prior distributions taken in anticipation of failure of the test. The statute authorizes the IRS to promulgate regulations defining what distributions are taken in anticipation of failure of the test, but it specifically states that any distribution made within two years before the failure will be treated as made in anticipation of such failure.
Reductions of Benefits Attributable to Nonpayment of Premiums
Any benefit reductions attributable to the nonpayment of premiums due are not taken into account if the benefits are reinstated within ninety days after being reduced. This rule applies to a nonforfeiture option of reduced paid-up insurance within the first seven contract years. In other words, if a policy that is put on reduced paid-up status fails the seven-pay test as a result of the look-back rule, the failure may be reversed if the policy is reinstated to its original death benefit within ninety days. Alternatively, failure of the test could probably be avoided by electing the extended-term option rather than the reduced paid-up option. The policy could also be surrendered without adverse consequences since the complete surrender of a life insurance policy during the policy’s first seven years is generally not considered to cause the policy to be treated as a MEC.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM