6.4 Policy Loans, Assignment, and Ownership Rights
Key Takeaways
- The policyowner controls beneficiary, loan, surrender, and assignment rights, which can differ from the insured and beneficiary.
- Policy loans against cash value are tax-free while in force; an unpaid loan plus interest is deducted from the death benefit or surrender value.
- A lapse or surrender with a loan can trigger taxable gain over basis as ordinary income (phantom income).
- A MEC fails the 7-pay test; its loans and withdrawals are taxed LIFO with a possible 10% penalty before 59 1/2, but the death benefit stays tax-free.
- Absolute assignment transfers all rights permanently; collateral assignment transfers limited rights to a lender up to the debt amount.
Ownership Rights
The policyowner holds the bundle of rights in a life insurance contract, which may or may not be the same person as the insured. Ownership rights include naming and changing the beneficiary (if revocable), selecting settlement and dividend options, taking policy loans, surrendering for cash value, and assigning the policy. The insured is simply the person whose life is covered; the beneficiary receives proceeds.
These three parties can be three different people. For example, a wife (owner) can insure her husband (insured) and name their child (beneficiary). The exam tests this separation, especially when asking who controls a given right — the answer is almost always the owner, except where an irrevocable beneficiary must consent.
Policy Loans
Permanent policies (whole life, universal life) build cash value the owner can borrow against through the policy loan provision. Term insurance has no cash value and therefore no loan privilege.
Key mechanics:
- The owner borrows against cash value; the insurer charges interest (fixed or variable per the contract).
- A loan is not taxable while the policy stays in force because it is debt, not a distribution.
- An unpaid loan plus accrued interest is deducted from the death benefit if the insured dies, or from cash value at surrender.
- The insurer may impose a short delay (often up to 6 months) before advancing a loan, except for loans used to pay premiums.
- Automatic premium loan (APL) is an option that automatically borrows cash value to pay an unpaid premium, preventing lapse.
Loan Trap: Lapse and Taxation
A loan is tax-free only while the policy remains in force. If the policy lapses or is surrendered with a loan outstanding, gain becomes taxable.
Worked example: A whole life policy has $60,000 cash value and a $50,000 loan; total premiums paid (cost basis) were $40,000. If the owner lets it lapse, the taxable amount is the gain over basis: $60,000 - $40,000 = $20,000 taxable as ordinary income. The loan does not erase the tax — the IRS treats the forgiven loan as part of the amount received.
This is why advisors warn against over-loaning a policy: a lapse can trigger a 'phantom' tax bill with no cash in hand.
A whole life policy has $60,000 cash value, a $50,000 outstanding loan, and a cost basis of $40,000 in premiums paid. The owner lets it lapse. What is the tax result?
Modified Endowment Contracts (MEC) and the 7-Pay Test
A policy that is over-funded with premiums becomes a Modified Endowment Contract (MEC) under the 7-pay test of IRC Section 7702A. The 7-pay test compares cumulative premiums paid in the first seven years against the premium that would have paid up the policy in seven level annual payments. If premiums paid exceed that limit, the contract is a MEC.
Consequences of MEC status:
- Living distributions (including loans and withdrawals) are taxed last-in, first-out (LIFO) — gain comes out first and is taxable.
- A 10% penalty applies to taxable amounts taken before age 59 1/2.
- The death benefit remains income-tax-free even for a MEC.
- Once a MEC, always a MEC — the status is permanent and follows the contract.
Trap: in a non-MEC policy, loans are tax-free, but in a MEC the same loan can be a taxable LIFO distribution with a penalty.
Which statement about a Modified Endowment Contract (MEC) is correct?
Assignment
Assignment is the transfer of policy rights from the owner to another party. Because the policy is property, the owner may use it as collateral or give it away.
| Type | What transfers | Common use |
|---|---|---|
| Absolute assignment | All ownership rights, permanently | Gifting the policy, sale, viatical/life settlement |
| Collateral assignment | Limited rights, temporarily, up to a debt amount | Securing a loan; lender is paid first from proceeds |
Under a collateral assignment, if the insured dies, the lender (assignee) is repaid the outstanding debt from the death benefit and the remainder goes to the beneficiary. The insurer must be notified of an assignment; it is not bound until it has notice. An irrevocable beneficiary must consent to any assignment.
Nonforfeiture and Owner Exits
When an owner stops paying on a permanent policy, nonforfeiture options protect accumulated cash value: take the cash surrender value, convert to reduced paid-up insurance (a smaller permanent policy, no more premiums), or buy extended term insurance (same face amount for a limited time — the default nonforfeiture option in most policies). These give the owner value even when exiting, completing the picture of ownership control.