4.4 Policy Loans, Withdrawals, and Assignments

Permanent life insurance lets the owner access cash value during life through policy loans and, on universal life, partial withdrawals. The owner can also transfer policy rights by assignment. These provisions are heavily tested because each has distinct mechanics and tax consequences, especially when a policy becomes a modified endowment contract (MEC).

A policy loan is not income when taken because it is borrowed money the owner must eventually repay — provided the policy stays in force and is not a MEC. This is one of life insurance's signature tax advantages: tax-free access to accumulated value.

The insurer must offer a policy loan provision on any policy with cash value. Loans accrue interest (fixed or variable per the contract), and the unpaid loan balance reduces both the cash value available and the death benefit paid at claim. The owner is never required to repay a policy loan during life — but unpaid interest compounds and can erode the policy.

Policy Loans and Automatic Premium Loan

Key loan features:

• The maximum loan is roughly the cash value minus one year's interest (insurers will not let a loan immediately exceed available value).
• Unpaid loans plus accrued interest are subtracted from the death benefit at claim and from the cash value at surrender.
• If a loan plus interest grows to exceed the cash value, the policy lapses — and a large lapse can trigger taxable gain ("phantom income") on the loan amount above basis.
• Automatic premium loan (APL) is an elective provision that automatically borrows from cash value to pay a premium that would otherwise lapse. It prevents unintentional lapse but quietly erodes cash value.

Example: Death benefit $250,000, outstanding loan $30,000 with $2,000 accrued interest. The beneficiary receives $250,000 − $32,000 = $218,000.

Loan interest rates may be a fixed contractual rate (e.g., 8%) or a variable rate tied to a published index such as Moody's Corporate Bond Yield. Many whole life contracts also offer a direct-recognition or non-direct-recognition dividend treatment: under direct recognition the insurer credits a different dividend rate on the borrowed portion of cash value. For the exam, the testable point is simpler — borrowing reduces the policy's working cash value and its net death benefit until repaid.

Withdrawals and the MEC / 7-Pay Test

Universal life allows partial withdrawals (partial surrenders) of cash value, which permanently reduce both the account value and usually the death benefit. Ordering for non-MEC policies is generally FIFO — basis (premiums) comes out first tax-free, then taxable gain.

Congress created the 7-pay test in 1988 to stop investors from using overstuffed life policies purely as tax shelters. A Modified Endowment Contract (MEC) is a life policy funded faster than the test allows — cumulative premiums in any of the first 7 years exceed the net level premiums that would pay the policy up in 7 years. Once a MEC, always a MEC, even if later funding slows; the policy is permanently tainted.

MEC distributions reverse to LIFO — gain (taxable) comes out first — and any pre-59½ distribution (including loans and withdrawals) faces a 10% penalty on the taxable portion.

Trap: even on a MEC, the death benefit stays income-tax-free. Only living distributions are penalized.

Why this matters in practice: a client who dumps a large single premium into a small whole life policy to "save money tax-free" may unknowingly create a MEC, converting future loans into taxable, penalized events. A producer should compare planned premiums to the 7-pay limit before recommending a heavily funded design. If MEC status is undesirable, the contract can be structured with a higher face amount (raising the 7-pay limit) so the same premium passes the test.

Assignments: Absolute vs. Collateral

An assignment transfers some or all ownership rights to another party. There are two types:

• Absolute assignment — a complete, permanent transfer of all ownership rights to the assignee (e.g., gifting a policy, a 1035 exchange, or selling the policy in a viatical/life settlement).
• Collateral assignment — a partial, temporary transfer used as security for a loan. The lender (assignee) can claim only the unpaid debt from the death benefit; the remainder goes to the named beneficiary. Full ownership reverts to the owner once the debt is repaid.

Assignment Mechanics and Notice

The owner must notify the insurer in writing to make an assignment effective against the company. The insurer is not bound until it receives notice, and it does not verify or guarantee the assignment's validity — it simply pays per the recorded assignment.

An irrevocable beneficiary must give written consent before the owner can assign the policy, take a loan, or change the beneficiary, because that beneficiary holds a vested interest. On a collateral assignment, the assignee has priority over the beneficiary only up to the outstanding loan balance.

Example: Death benefit $300,000 with a $50,000 bank loan under collateral assignment. At the insured's death the bank receives $50,000 and the named beneficiary receives the remaining $250,000. Under an absolute assignment, by contrast, the assignee would control the entire $300,000 and all policy rights.