4.4 Policy Loans, Withdrawals, and Assignments

Permanent life policies let owners access cash value while alive through policy loans and withdrawals, and they let owners transfer rights through assignment. The exam tests the mechanics, the interest and repayment rules, the death-benefit impact, and the critical MEC taxation rules that can convert a tax-advantaged policy into a taxable one.

Policy Loans

A policy loan borrows against the cash value using the policy as collateral. Key features:

• No credit check and no fixed repayment schedule.
• Interest accrues (fixed or variable per the contract).
• An unpaid loan plus interest is deducted from the death benefit if the insured dies, and from the cash surrender value on surrender.
• If the loan plus interest ever exceeds the cash value, the policy lapses.

Loan proceeds are not taxable while the policy is in force and is not a MEC, because a loan is debt, not income.

Withdrawals (Partial Surrenders)

Universal life and similar flexible policies allow withdrawals (partial surrenders) of cash value. Unlike a loan, a withdrawal permanently removes money and usually reduces the death benefit dollar-for-dollar.

Taxation of withdrawals from a non-MEC policy follows FIFO (cost recovery): amounts up to total premiums paid (basis) come out tax-free first; only amounts above basis are taxed as ordinary income.

Worked example: An owner paid $20,000 in premiums and withdraws $14,000. Because $14,000 is below the $20,000 basis, the entire withdrawal is tax-free. If a later withdrawal pushes cumulative withdrawals above $20,000, the excess is taxable as ordinary income.

Modified Endowment Contracts (MEC) and the 7-Pay Test

A policy becomes a Modified Endowment Contract (MEC) 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). MECs are overfunded contracts that lost their favorable distribution tax treatment.

Worked example: A MEC has a $25,000 basis and $40,000 cash value (gain $15,000). The owner, age 50, takes a $10,000 loan. Under LIFO the full $10,000 is taxable gain, plus a 10% penalty ($1,000) because the owner is under 59 1/2. Total tax cost: ordinary income on $10,000 plus $1,000 penalty.

Assignment of the Policy

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

• Absolute assignment: a permanent, complete transfer of all ownership rights to a new owner (e.g., gifting or selling the policy). It is irrevocable.
• Collateral assignment: a partial, temporary transfer used as loan security, commonly to a bank. The lender is repaid first from proceeds up to the loan balance; the rest goes to the beneficiary. The owner keeps all other rights.

The owner must notify the insurer of an assignment; the insurer is not responsible for the validity of an assignment but acts on the most recent notice received.

Loans vs. Withdrawals: Choosing the Right Access

The exam frequently asks which living-benefit method a client should use, so know the practical differences.

A loan preserves the ability to restore full coverage by repayment and is ideal for short-term needs, but accruing interest is a silent danger. A withdrawal suits a client who wants to permanently reduce coverage and the premium. Both methods are tax-favored only in a non-MEC policy; in a MEC, both trigger LIFO taxation and the possible 10% early-distribution penalty discussed above. Always confirm MEC status before recommending either.

Putting the 7-Pay Test in Context

Congress created the MEC rules in 1988 to stop investors from using life insurance purely as a tax shelter by stuffing in large premiums. The 7-pay test measures cumulative premiums paid against the cumulative net level premiums that would pay the policy up in seven years. Cross that line, and the contract is permanently classified as a MEC.

Key points the exam stresses: a MEC is determined at issue and remains a MEC for life; a material change (such as increasing the death benefit) restarts the 7-pay test; and the MEC label affects only living distributions, never the income-tax-free death benefit. Reduced face amounts during the first seven years can also retroactively trigger MEC status. Single-premium whole life is almost always a MEC because the entire premium is paid at once.

Trap: Loans/withdrawals from a non-MEC are taxed FIFO (basis first, tax-free); from a MEC they are taxed LIFO (gain first, taxable) with a possible 10% penalty before age 59 1/2.