Policy Loans, Withdrawals, and Assignments

Policy Loans, Withdrawals, and Assignments

The living benefits of a permanent policy—loans, withdrawals, and the right to assign the contract—are exam favorites because they intersect with taxation and the modified endowment contract (MEC) rules. A policy with cash value gives the owner access to that value during life, but each method carries different consequences for the death benefit and the tax bill.

The policy loan provision requires the insurer to lend up to the available cash value at a stated or variable interest rate. The insurer cannot decline a properly requested loan, though it may defer payment up to six months (except for loans used to pay premiums).

State law caps how a loan rate is set: a policy must specify either a fixed maximum rate (commonly 8%) or a variable rate tied to a published index such as Moody's Corporate Bond Yield. Borrowing against the policy reduces the cash value available to support the contract, so unpaid interest is added to the loan balance and can, if it grows large enough, cause the policy to lapse—a risk the exam links to overborrowing.

Loans and the Death Benefit

A policy loan is not taxable while the policy stays in force, because the owner is borrowing against the contract. However, any unpaid loan balance plus accrued interest is subtracted from the death benefit. Borrow $20,000 against a $150,000 policy and die before repaying, and beneficiaries receive $130,000 (less accrued interest).

The automatic premium loan (APL) provision, if elected, automatically borrows from cash value to pay a premium that would otherwise lapse, preventing unintended termination. It is a useful default but steadily erodes cash value if relied on repeatedly.

Withdrawals vs. Loans

Universal life allows partial withdrawals (surrenders) of cash value, which differ from loans:

In a non-MEC policy, withdrawals follow FIFO—you withdraw your own premium (basis) first tax-free, and only gain above basis is taxable.

The MEC 7-Pay Test

A policy becomes a Modified Endowment Contract if cumulative premiums in the first seven years exceed the 7-pay limit—the level annual premium that would pay the policy up in seven years. Overfunding to abuse the tax shelter triggers MEC status.

Once a MEC, the policy loses favorable living-benefit taxation. Loans and withdrawals are taxed LIFO (gain comes out first and is taxable), and amounts taken before age 59½ incur a 10% penalty. The death benefit remains income-tax-free, but the living-benefit advantages are gone—and MEC status is permanent.

A practical MEC trap: rolling cash from a maturing policy or making a large lump-sum 'dump-in' can blow the 7-pay limit even on a properly designed contract. Once tagged, exchanging the MEC into a new policy under a 1035 exchange carries the MEC taint forward—the new contract is also a MEC. The 7-pay test resets only if there is a material change (such as an increase in death benefit), which starts a fresh seven-year measuring period. Because MEC consequences are permanent and severe for living benefits, agents must counsel clients on funding limits before overpaying.

Assignments

The assignment provision lets the owner transfer rights in the policy.

• Absolute assignment – a complete, permanent transfer of all ownership rights to another party (for example, a charity or buyer in a life settlement).
• Collateral assignment – a partial, temporary transfer that pledges the policy as security for a debt; the assignee (a bank) is repaid from proceeds only up to the loan balance, with the remainder going to the named beneficiary.

An irrevocable beneficiary must consent to any assignment. The insurer is not responsible for the validity of an assignment—only for honoring properly filed notice.

Distinguish assignment from a beneficiary change. Changing a beneficiary names who collects proceeds at death; an assignment transfers ownership rights during life. A viatical or life settlement is an absolute assignment in which a terminally or chronically ill insured sells the policy for a lump sum exceeding its cash value but less than the face amount; the buyer then pays future premiums and collects the death benefit. Proceeds from a qualified viatical settlement for a terminally ill insured are generally received income-tax-free, mirroring the tax treatment of accelerated death benefit riders.

Always confirm the assignee files written notice with the insurer so the company can honor the transfer at claim time.

Worked Policy-Loan Mechanics

Loan questions turn on a few numbers. A whole life policy with $25,000 of cash value lets the owner borrow up to that amount at a contractual rate, say 6% or 8% fixed, or a variable rate tied to an index. The insurer is not actually lending the owner's own money back so much as advancing against the guaranteed cash value, and the loan need never be repaid on a schedule. The catch the exam stresses: any outstanding loan balance plus accrued interest is subtracted from the death benefit. A $200,000 policy with a $25,000 loan and $3,000 of accrued interest pays the beneficiary $172,000.

Unpaid interest is the silent killer. If loan interest is not paid in cash, the insurer adds it to the loan balance, which then accrues further interest, so an aging loan can eventually exceed the cash value and force the policy to lapse, triggering a taxable event on the gain. Distinguish the three living-access routes by tax result: a policy loan from a non-MEC is income-tax-free while the policy stays in force; a partial surrender or withdrawal is tax-free up to basis under FIFO for a non-MEC; and any distribution from a MEC is taxed LIFO with a possible 10% penalty before age 59 1/2.

Automatic premium loan provisions add another wrinkle, quietly borrowing from cash value to pay a missed premium and prevent lapse, which keeps coverage in force but steadily erodes both cash value and the net death benefit.