4.4 Policy Loans, Withdrawals, and Assignments

Policy Loans

Permanent policies with cash value include a policy loan provision. The owner borrows from the insurer using the cash value as collateral. Critical exam facts:

• The insurer must grant the loan up to the available cash value (after a brief deferral period, typically up to 6 months, except loans to pay premiums).
• A policy loan is not taxable while the policy is in force (it is a loan, not a distribution) — provided the policy is not a Modified Endowment Contract.
• Interest accrues; if unpaid, it is added to the loan balance.
• Any outstanding loan plus accrued interest is deducted from the death benefit if the insured dies before repayment.

Loans reduce the net death benefit dollar-for-dollar. A $250,000 policy with a $40,000 loan and $3,000 accrued interest pays the beneficiary $250,000 − $43,000 = $207,000.

Withdrawals (Partial Surrenders)

Universal life and similar flexible policies allow withdrawals (partial surrenders) of cash value, which differ from loans:

• A withdrawal permanently reduces cash value and usually the death benefit; it is not repaid.
• Withdrawals are taxed on a FIFO basis (cost basis out first, then gain) for non-MEC policies — so withdrawals up to total premiums paid are generally tax-free.
• Surrender charges may apply in early policy years.

Contrast with a loan, which is taxed only if the policy lapses or is surrendered with a gain still owed.

The MEC Trap — 7-Pay Test

A Modified Endowment Contract (MEC) is a life policy funded faster than the 7-pay test allows — i.e., cumulative premiums in the first seven years exceed the net level premiums needed to pay the policy up in seven years. Once a policy is a MEC, it stays a MEC.

MEC tax consequences flip the normal rules:

Example: a policyholder overfunds a whole life policy with $30,000 in year one when the 7-pay limit is $9,000 per year — the policy becomes a MEC. A later $15,000 loan is now taxed as income to the extent of gain, plus a 10% penalty if the owner is under 59½.

Assignments

An assignment transfers some or all policy rights to another party. Two types:

• 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 the policy.
• Collateral assignment — a partial, temporary transfer, typically to a lender as security for a loan. The lender is repaid from proceeds only up to the debt; any remainder goes to the named beneficiary. The owner keeps all other rights.

The owner must notify the insurer of an assignment for it to be effective against the insurer, though the insurer does not have to approve it. Do not confuse assignment (transfer of rights) with beneficiary change (who receives proceeds).

Loan vs Withdrawal — Side by Side

The practical guidance: a loan preserves the option to restore full coverage by repaying; a withdrawal is a permanent decision. Both can cause a lapse if they drain the cash value needed to keep the policy in force.

The Three Tax Buckets to Memorize

For any life-insurance taxation question, sort the cash flow into one of three buckets:

1. Death benefit — paid to a named beneficiary, almost always income-tax-free regardless of MEC status.
2. Living distributions on a non-MEC — loans not taxed while in force; withdrawals FIFO (basis first, tax-free up to premiums paid); full surrender taxes only the gain above basis.
3. Living distributions on a MEC — LIFO (gain taxed first) plus a 10% penalty before age 59½.

Knowing which bucket a transaction falls into lets you answer the taxation traps quickly and consistently.

Absolute vs. Collateral Assignment

An assignment transfers some or all policy rights to another party, and the exam draws a sharp line:

• Absolute assignment — a complete, permanent transfer of ownership (e.g., gifting a policy or a viatical/life settlement sale). The new owner gains all rights.
• Collateral assignment — a partial, temporary transfer of rights to a creditor (often a bank) as security for a loan. The creditor can collect only up to the outstanding debt; any remaining death benefit goes to the named beneficiary.

Worked collateral example: A policyowner collaterally assigns a $200,000 policy to a bank securing a $60,000 loan, then dies with $45,000 still owed. The bank receives $45,000; the named beneficiary receives the remaining $155,000. The creditor never collects more than the debt — a frequent calculation question.

Policy Loan Mechanics and the Lapse Risk

Policy loans accrue interest (fixed or variable, disclosed at issue) and reduce the death benefit and cash value dollar-for-dollar until repaid. Loans are not taxable while the policy stays in force because they are debt, not distributions. But if the policy lapses or is surrendered with a loan outstanding, the loan amount above basis becomes taxable income — a nasty surprise the exam loves. On a MEC, loans are taxed immediately as LIFO income plus a 10% penalty before 59½, unlike loans on a non-MEC policy.