4.4 Policy Loans, Withdrawals, and Assignments

Cash value gives the policyowner living access to money through policy loans and, in some products, withdrawals. Ownership rights can also be transferred through assignment. These features are heavily tested for their mechanics, their effect on the death benefit, the MEC tax trap, and the difference between the two kinds of assignment.

Policy Loans

A policy loan borrows against the cash value, using the policy as collateral. The exam emphasizes these points:

• The insurer must make the loan up to the available cash value (a required provision in cash-value policies).
• A loan is not taxable while the policy stays in force — it is borrowed money, not income.
• Interest is charged; unpaid interest is added to the loan balance.
• An outstanding loan plus accrued interest reduces the death benefit dollar-for-dollar if not repaid before death.
• The insurer may defer a loan request up to 6 months (except loans to pay premiums).

Automatic Premium Loan (APL)

An optional provision: if a premium is unpaid at the end of the grace period, the insurer automatically borrows from the cash value to pay it, preventing lapse. This protects the policy but steadily erodes cash value and death benefit if relied on repeatedly.

Loan Interest Rates

Policy loan interest may be a fixed rate stated in the contract or a variable (adjustable) rate tied to a published index. The exam point is simply that interest accrues; if it is not paid in cash, it is added to the loan balance and compounds, accelerating the erosion of cash value and the death benefit. An owner who borrows and never repays can eventually see the loan plus interest approach the cash value, risking lapse of the policy.

Repaying a Loan

Repayment is optional, but partial or full repayment restores the death benefit and reduces future interest. There is no fixed repayment schedule — unlike a bank loan, the insurer cannot demand repayment as long as the cash value covers the balance.

Withdrawals and the MEC Trap

Withdrawals (partial surrenders) are available chiefly on universal life and variable products, not standard whole life. They permanently reduce cash value and usually the death benefit.

FIFO vs. LIFO Taxation

• A normal (non-MEC) life policy is taxed FIFO (first-in, first-out): withdrawals come out of your basis (premiums paid) first and are tax-free until you exceed basis.
• A Modified Endowment Contract (MEC) is taxed LIFO (last-in, first-out): gains come out first and are taxable, and a 10% penalty applies before age 59½ — just like an annuity.

The 7-Pay Test

A policy becomes a MEC if cumulative premiums paid during the first 7 years exceed the 7-pay limit — the level annual premium that would fully pay up the policy in 7 years. Overfunding to gain tax-free build-up triggers MEC status.

Worked example: A policy's 7-pay limit is $6,000/year ($42,000 over 7 years). The owner pays $10,000 in year one. Because $10,000 exceeds the $6,000 cumulative limit for that point, the contract becomes a MEC. Thereafter, any loan or withdrawal is taxed LIFO (gain first) with a 10% penalty before 59½.

• Once a MEC, always a MEC — the status cannot be reversed.
• The death benefit of a MEC is still income-tax-free; only living distributions are penalized.

Assignment of the Policy

Assignment transfers some or all ownership rights, usually to secure a debt or make a gift.

• Under a collateral assignment, if the insured dies, the lender (assignee) is paid only the outstanding debt; the remaining death benefit goes to the named beneficiary.
• The owner must notify the insurer of an assignment, but the insurer is not responsible for its validity.
• An irrevocable beneficiary must consent before the owner can assign the policy.

Absolute vs. Collateral — Worked Example

An owner collaterally assigns a $200,000 policy to a bank securing a $50,000 business loan. The insured dies while $50,000 is still owed. The bank (assignee) receives $50,000; the remaining $150,000 goes to the named beneficiary. Had the owner instead made an absolute assignment to the bank, the bank would become the new owner with full rights to the entire policy.

A viatical or life settlement is implemented through an absolute assignment: a terminally or chronically ill insured sells the policy to a third party (the viatical company) for more than the cash value but less than the face amount. The buyer becomes owner and beneficiary and collects the full face at death. Proceeds to a terminally ill insured are generally income-tax-free under federal rules, an exam-tested benefit. The owner must still notify the insurer of any assignment, and the insurer is not liable for validating its terms.