4.4 Policy Loans, Withdrawals, and Assignments

Cash-value policies let the owner tap equity during life through policy loans and partial withdrawals, and let the owner transfer rights through assignment. These living-benefit features are heavily tested because of their effect on the death benefit, on lapse risk, and on taxation — including the Modified Endowment Contract (MEC) rules that can convert a tax-favored policy into a tax trap.

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Policy Loans

The owner may borrow against the cash value at the contract's loan interest rate. Key rules:

• The insurer cannot refuse a loan up to the available cash value.
• A loan is not taxable while the policy stays in force (it is debt, not income).
• An unpaid loan plus interest reduces the death benefit dollar-for-dollar at death.
• The automatic premium loan (APL) provision pays an overdue premium by taking a loan against cash value, preventing unintended lapse.
• If the policy lapses or is surrendered with an outstanding loan, the gain becomes taxable in the year of lapse — a classic surprise tax bill.

Worked example: A $100,000 whole life policy has a $12,000 loan with $600 of accrued interest when the insured dies. The beneficiary receives $100,000 − $12,600 = $87,400.

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Withdrawals and the Cost Basis Rules

Universal life and similar policies allow partial withdrawals (partial surrenders) of cash value. Withdrawals reduce the cash value and usually the death benefit. Taxation follows FIFO for ordinary (non-MEC) life insurance: amounts up to the cost basis (total premiums paid) come out tax-free first, and only amounts above basis are taxable.

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The MEC 7-Pay Test (Critical Tax Trap)

A policy becomes a Modified Endowment Contract (MEC) if it is funded too quickly, failing the 7-pay test: cumulative premiums in any of the first 7 years exceed the net level premium that would have paid the policy up in 7 years.

Once a contract is a MEC, distributions are taxed LIFO — gain (interest) comes out first and is fully taxable, the opposite of normal FIFO treatment — and a 10% penalty applies to taxable amounts taken before age 59½. Loans from a MEC are treated as distributions and are taxable. Once a MEC, always a MEC, and the taint carries to a policy received in exchange.

• 7-pay test window: first 7 years (also re-tested after a material change).
• MEC death benefit remains income-tax-free — only living distributions are affected.
• MEC status does not change the policy's insurance protection, only its tax treatment.

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Assignment

The owner may transfer policy rights to another party. Two forms:

1. Absolute assignment — a complete, permanent transfer of all ownership rights (e.g., a charitable gift). The new owner controls the contract.
2. Collateral assignment — a partial, temporary transfer used as collateral for a loan (commonly a bank). The lender is repaid first from proceeds up to the debt; the remaining balance goes to the named beneficiary.

The insurer must receive written notice of any assignment to be bound; the insurer does not have to approve it. Assignment differs from a beneficiary change — assignment transfers ownership rights, while a beneficiary change only redirects proceeds.

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Loans vs. Withdrawals: Which to Use

Producers weigh loans against withdrawals based on the client's tax basis and intent to repay:

• A loan keeps the cash value technically intact (it remains in the policy as collateral), preserves the policy's tax-deferred growth, and is repayable, but it accrues interest and shrinks the death benefit until repaid.
• A withdrawal permanently removes cash value and, on a universal life policy, may reduce the face amount; it is irreversible but carries no loan interest.
• For non-MEC policies, withdrawing only up to cost basis is the tax-efficient way to access funds, after which switching to loans avoids triggering taxable gain.

Worked example: An owner has paid $30,000 in premiums into a non-MEC universal life policy now worth $50,000 cash value. She may withdraw up to $30,000 tax-free (return of basis under FIFO). To access the remaining $20,000 of gain without tax, she takes a policy loan rather than a withdrawal, leaving the gain inside the contract.

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The Lapse-With-Loan Tax Surprise

The most dangerous combination on the exam is a lapsing policy with a large loan. While in force, a loan is tax-free. But if the policy lapses or is surrendered with the loan outstanding, the loan is treated as a distribution: the gain (cash value minus basis), including amounts used to repay the loan, becomes taxable — sometimes producing a tax bill with no cash in hand to pay it. This is why the automatic premium loan provision and careful loan monitoring matter, and why examiners pair "lapse" with "taxable gain" as the correct answer.