4.4 Policy Loans, Withdrawals, and Assignments

Permanent policies let the owner access the living values through policy loans and, in flexible-premium contracts, withdrawals. The owner can also transfer rights through assignment. Each of these has distinct mechanics, tax consequences, and a critical interaction with the Modified Endowment Contract (MEC) rules that the exam tests carefully. Term policies, having no cash value, offer none of these living benefits.

Policy Loans

A policy loan lets the owner borrow against the cash value. Key features the exam tests:

• The insurer must offer loans once cash value exists; there is no credit check and no repayment schedule because the cash value is the collateral.
• Interest accrues at the contract rate (fixed or variable). The owner is not required to repay, but any unpaid loan plus accrued interest is subtracted from the death benefit paid to the beneficiary.
• A loan is not taxable while the policy stays in force, because it is borrowed money, not a distribution, as long as the policy is not a MEC.
• If the loan plus interest ever exceeds the cash value, the policy can lapse, which can trigger a taxable gain ("phantom income") even though the owner received no new cash. Insurers must send a notice before such a lapse.

Withdrawals and the FIFO/LIFO Rule

Universal life and similar flexible policies permit partial withdrawals (partial surrenders) of cash value. For a non-MEC policy, withdrawals follow FIFO (first-in, first-out): the owner withdraws cost basis (premiums paid) first, tax-free, and only amounts above basis are taxable.

The MEC Trap (7-Pay Test)

A policy becomes a Modified Endowment Contract if cumulative premiums in the first 7 years exceed the 7-pay limit, the level annual premium that would pay the policy up in 7 years. A MEC is still life insurance for the death benefit, but living distributions are taxed like an annuity:

• Loans and withdrawals from a MEC are taxed LIFO (last-in, first-out), gain comes out first and is taxable.
• Distributions before age 59 1/2 also incur a 10% penalty.
• A loan from a MEC is a taxable distribution, unlike a loan from a normal policy.

The MEC rules exist to stop people from using life insurance purely as a tax shelter, dumping in large sums to grow cash tax-deferred and then borrowing it out tax-free. Once a contract fails the 7-pay test it is permanently a MEC, and so is any policy received in exchange for a MEC. Practical tip: a 1035 exchange of a MEC produces another MEC, and over-funding through paid-up additions or a large single premium is the usual way a policy trips the test.

Assignment

An assignment transfers some or all of the owner's rights to another party. The owner does not need the insurer's permission to assign, but the assignment is not binding on the insurer until it receives written notice. There are two forms:

• Absolute assignment - a complete, permanent transfer of all ownership rights (for example, a gift, a sale, or a charitable donation). The assignee becomes the new owner with full control.
• Collateral assignment - a partial, temporary transfer used as collateral for a loan. The lender (assignee) is paid from the proceeds only up to the outstanding debt; the balance goes to the named beneficiary. The owner keeps all other rights. This is common in business lending and SBA loans.

The owner must notify the insurer of an assignment; the insurer is not responsible for the validity of an assignment it has not received. An irrevocable beneficiary must consent before the owner assigns the policy, because assignment can impair that beneficiary's vested interest.

Worked example

An owner takes a $40,000 collateral assignment to secure a business loan. The insured later dies with $35,000 still owed and a $250,000 death benefit. The lender receives $35,000 (the outstanding debt only); the named beneficiary receives the remaining $215,000. Had this been an absolute assignment, the assignee would control the entire benefit.

Loan Mechanics, Automatic Premium Loan, and the MEC Trap

A policy loan lets the owner borrow up to the cash surrender value at a contractually stated or variable interest rate. The loan is not taxable while the policy stays in force, because it is debt, not a distribution - but any unpaid loan balance plus accrued interest is subtracted from the death benefit. If the loan plus interest ever exceeds the cash value, the policy lapses, and the gain above basis becomes taxable in the year of lapse, a nasty surprise the exam tests.

The automatic premium loan (APL) provision prevents accidental lapse by borrowing the cash value to pay a missed premium. Distinguish loans from partial withdrawals on universal life: withdrawals come out basis-first (FIFO) and are tax-free up to basis, while loans are separate debt.

Assignments

An absolute assignment is a permanent, complete transfer of ownership (used in viatical sales or charitable gifts). A collateral assignment is a partial, temporary transfer to a lender as security for a loan - if the insured dies, the lender is paid the outstanding balance first and the named beneficiary receives the remainder.