4.4 Policy Loans, Withdrawals, and Assignments

Policy Loans, Withdrawals, and Assignments

This section covers the living-benefit access features of permanent life insurance — borrowing against cash value, withdrawing from universal life, surrendering, and transferring ownership — plus the MEC rules that can wreck the tax treatment. Each carries distinct tax and death-benefit consequences that examiners test heavily.

Policy Loans

A policy loan lets the owner borrow against the cash value at a contractually stated or variable interest rate. Key facts:

• Loans are not taxable while the policy stays in force (the owner is borrowing, not receiving income).
• The insurer cannot refuse a loan request up to the available cash value; it may defer payment up to 6 months (except for paying premiums).
• An unpaid loan plus accrued interest reduces the death benefit and cash value dollar-for-dollar.
• If the policy lapses or is surrendered with a loan outstanding, the gain (loan amount minus basis) becomes taxable — a frequent trap.

Worked example: A whole life policy has a $60,000 death benefit and a $12,000 outstanding loan with $800 accrued interest. The insured dies. The beneficiary receives $60,000 − $12,800 = $47,200.

Withdrawals (Universal Life)

Universal life (UL) permits partial withdrawals (partial surrenders) of cash value, which whole life does not. Withdrawals follow FIFO taxation for non-MEC policies — the cost basis (premiums) comes out first tax-free, and only amounts above basis are taxable. Withdrawals permanently reduce the cash value and may reduce the death benefit.

Modified Endowment Contract (MEC) — 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 still life insurance, but living-benefit distributions lose favorable tax treatment:

• Distributions (loans, withdrawals, surrenders) are taxed LIFO — gain (interest) comes out first and is taxable.
• A 10% penalty applies to taxable amounts taken before age 59½.
• The death benefit remains income-tax-free even for a MEC.
• "Once a MEC, always a MEC" — the status cannot be reversed, and it taints the policy permanently.

Trap: Overfunding a policy (dumping cash to maximize tax-deferred growth) is exactly what triggers MEC status. The 7-pay test is the line not to cross.

Assignments

An assignment transfers policy rights. Two forms:

• Absolute assignment is a complete, permanent transfer of ownership (e.g., to a new owner or a trust).
• Collateral assignment is partial and temporary — the lender is paid from proceeds only up to the debt, with the remainder to the named beneficiary.
• The owner must notify the insurer of an assignment; the insurer is not responsible for the validity of the assignment.

Viatical and Life Settlements

An absolute assignment is the mechanism behind a viatical settlement (sale by a terminally or chronically ill insured) and a life settlement (sale by an older insured of a no-longer-needed policy) to a third-party investor for more than cash value but less than face. Viatical proceeds to a terminally ill insured are generally income-tax-free; ordinary life-settlement proceeds may be partly taxable above cost basis. The buyer becomes the new owner and beneficiary and pays future premiums.

Coordination Trap

Do not confuse assignment (transferring rights) with beneficiary change (naming who receives proceeds). An absolute assignment moves ownership; it does not by itself change the beneficiary unless the new owner makes that change. Likewise, an irrevocable beneficiary must consent before the owner can assign the policy, take a loan that impairs the benefit, or change the beneficiary. These consent rules are heavily tested — an irrevocable designation strips the owner of unilateral control.

Loan Interest, Spread, and the 1035 Exchange

Policy loans accrue interest at a fixed or variable rate stated in the contract. Because cash value continues to earn interest, the real cost is the net spread between the loan rate and the credited rate. Unpaid loans plus accrued interest are subtracted from the death benefit. If a loan causes a policy to lapse, any gain becomes taxable even though no cash was received - a frequent surprise.

Section 1035 Exchanges

A 1035 exchange lets an owner swap one contract for another without triggering current tax on the gain.

Worked trap: you may exchange life-to-annuity tax-free but never annuity-to-life, because that would convert taxable annuity gain into a tax-free death benefit. A viatical settlement lets a terminally ill insured sell the policy for cash; proceeds are income-tax-free when the insured is certified terminally ill (life expectancy under 24 months), but a sale by a chronically ill or healthy insured (a life settlement) can be taxable.