4.4 Policy Loans, Withdrawals, and Assignments

Policy Loans

A policy loan lets the owner borrow against the cash value of a permanent policy. The cash value is the collateral, so the insurer cannot decline the loan once value exists, and there is no credit check or repayment schedule. Key mechanics tested nationally:

• Loans accrue interest (fixed or variable per contract). Unpaid interest is added to the loan balance and itself accrues interest.
• The owner is never required to repay a policy loan during life. But any outstanding loan plus accrued interest is deducted from the death benefit if the insured dies, or from the cash value at surrender.
• A loan is not taxable while the policy stays in force as a non-MEC — it is a loan, not income.
• If a loan plus interest erodes the cash value to zero, the policy can lapse; the Automatic Premium Loan rider can prevent lapse on missed premiums but not on loan overgrowth.

Loans vs. Withdrawals (Partial Surrenders)

Universal life permits partial withdrawals (partial surrenders) directly from the cash value — distinct from a loan:

Withdrawals from a non-MEC follow FIFO (first-in, first-out): you withdraw your own premiums (basis) tax-free first, and only amounts above basis are taxable. This is the reverse of annuity withdrawals, which use LIFO.

The MEC Trap (7-Pay Test)

If a policy is over-funded faster than a 7-pay limit — meaning cumulative premiums in the first seven years exceed what would pay the policy up in seven level annual premiums — it becomes a Modified Endowment Contract (MEC). Once a MEC, always a MEC. The death benefit stays income-tax-free, but living distributions reverse to LIFO and become punitive:

• Loans and withdrawals are taxed gain-first (LIFO) as ordinary income.
• A 10% penalty applies to taxable amounts taken before age 59½ (similar to qualified-plan rules).

Worked example: A policy with a 7-pay annual limit of $9,000 receives $15,000 in year one. The $6,000 excess breaches the 7-pay test and the contract is classified a MEC. A later $20,000 loan, if the policy holds $12,000 of gain, would tax $12,000 as ordinary income (LIFO gain first) plus a $1,200 penalty if the owner is under 59½.

Assignments

An assignment transfers some or all of the owner's contractual rights to a third party. There are two kinds:

• Absolute assignment — a complete, permanent transfer of all ownership rights to the assignee (e.g., gifting a policy or a charitable transfer). The new owner controls everything.
• Collateral assignment — a partial, temporary transfer used to secure a debt (often a bank loan). The lender is paid from proceeds only up to the outstanding debt; any remainder goes to the named beneficiary. Once the debt is repaid, full rights revert to the owner.

The insurer must receive written notice of an assignment but does not have to consent and is not responsible for its validity. An assignment is not the same as a beneficiary change — assignment transfers ownership rights, while a beneficiary change only redirects proceeds. A common exam contrast: changing a revocable beneficiary needs no one's permission, but an absolute assignment of the contract permanently strips the original owner of the very right to make that change.

Loan Interest, Indebtedness, and Lapse Mechanics

Policy-loan interest is usually charged in arrears and, if unpaid, is capitalized — added to the principal so it compounds. Over years a modest loan can balloon. When total indebtedness (loan plus accrued interest) approaches the cash value, the insurer sends a notice; if the owner does not pay down the loan or add premium, the policy lapses for excess indebtedness. A lapse with an outstanding loan can trigger a surprise tax bill, because the forgiven loan above basis is treated as a taxable distribution even though the owner received no new cash — a classic 'phantom income' trap the exam likes to spring.

Putting the Tax Order Straight

Memorize the three withdrawal-order rules side by side, because the exam mixes them:

• Non-MEC life insurance distributions: FIFO — basis first (tax-free), gain last (taxable).
• Annuities: LIFO — gain first (taxable), basis last.
• MECs: LIFO like annuities, plus a 10% penalty on taxable amounts before age 59½.

The death benefit, by contrast, is income-tax-free in every case (MEC or not), which is why MEC status hurts only living distributions. If a question stresses fast over-funding within seven years, suspect a MEC and switch your withdrawal logic to gain-first.

Why Owners Borrow Instead of Surrender

The planning payoff of the loan provision is that a non-MEC owner can access cash value tax-free by borrowing, while a surrender of the same amount above basis would be taxable. The trade-off is the interest cost and the reduction of the net death benefit while the loan is outstanding. For a client who needs liquidity but wants to keep coverage, a loan beats a surrender; for a client who no longer needs coverage at all, surrender (or a 1035 exchange into an annuity) is cleaner. Recognizing the client's coverage need is how the exam distinguishes the right tool.

Notice, Consent, and Recordkeeping

Although the insurer need not approve an assignment, it must record proper written notice to know whom to pay; an insurer that pays the original owner before receiving notice is protected. Similarly, a beneficiary change generally takes effect when the insurer records the owner's written request (the 'recording' method), though some contracts use the 'endorsement' method requiring the policy to be sent in. For an irrevocable beneficiary, remember that no assignment, loan, surrender, or beneficiary change can proceed without that beneficiary's signed consent — the single most-tested limit on owner control.