4.4 Policy Loans, Withdrawals, and Assignments

Permanent cash value can be accessed during life through policy loans and withdrawals, and ownership rights can be transferred through assignment. These features create living flexibility but carry tax traps — especially the Modified Endowment Contract (MEC) rules and the 7-pay test — that the exam tests with worked numbers.

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Policy Loans

A policy loan lets the owner borrow against cash value. Key facts:

• The insurer must honor a loan request up to the available cash value (loan provision is guaranteed).
• Loans accrue interest; the policy may use a fixed or variable rate.
• An unpaid loan plus interest reduces the death benefit dollar-for-dollar at the insured's death.
• A loan on a non-MEC policy is not a taxable event, even though it draws on untaxed gain.
• The automatic premium loan (APL) provision automatically borrows from cash value to pay a premium that would otherwise lapse — preventing unintentional lapse.

Trap: if a loan plus interest grows to exceed the cash value, the policy can lapse. If a policy with an outstanding loan that exceeds basis lapses or is surrendered, the gain becomes taxable income even though the owner received no new cash.

Distinguish a policy loan from a withdrawal: a loan is borrowed money that can be repaid and leaves the cash value intact as collateral, while a withdrawal permanently removes cash value. Loans do not reduce the cash value on the books (it secures the loan), but withdrawals do. Both can reduce the death benefit if not repaid or restored.

Withdrawals (Partial Surrenders)

Universal life allows withdrawals of cash value. Unlike a loan, a withdrawal permanently removes money and usually reduces the death benefit. Withdrawals are taxed FIFO (first-in, first-out) on a non-MEC policy: basis (premiums paid) comes out first tax-free, then gain is taxable. MECs reverse this.

Universal life offers two death benefit designs that interact with withdrawals. Option A (Level) keeps the face level, so the net amount at risk shrinks as cash value grows; a withdrawal lowers the face. Option B (Increasing) pays face plus cash value, keeping the net amount at risk roughly constant and costing more. Knowing which option is in force tells you how a withdrawal affects the payout.

The 7-Pay Test and MECs

The 7-pay test (TAMRA, 1988) limits how fast a policy can be funded. If cumulative premiums paid in the first 7 years exceed the amount needed to pay the policy up in 7 level annual premiums, the contract becomes a Modified Endowment Contract (MEC).

Consequences of MEC status:

Worked example: A policy's 7-pay limit is $9,000/year. The owner pays $12,000 in year one. Cumulative premiums ($12,000) exceed the 7-pay limit, so the contract is classified a MEC — permanently. A later $5,000 loan is now taxed LIFO as gain first, plus a 10% penalty if the owner is under 59½. The death benefit, however, remains income-tax-free. Once a MEC, always a MEC.

Assignment

An assignment transfers policy rights to another party. Two forms:

• Absolute assignment: complete, permanent transfer of all ownership rights (e.g., gifting or selling the policy).
• Collateral assignment: partial, temporary transfer of rights to a lender as loan security; only enough death benefit to cover the debt goes to the lender, and the rest goes to the named beneficiary.

The owner must notify the insurer, but the insurer does not have to approve the assignment — a key distinction from a beneficiary change, which the owner controls outright unless the beneficiary is irrevocable.

A practical note on priority: if a collateral assignee (lender) and a revocable beneficiary both have claims, the assignee is paid first up to the debt, and the beneficiary receives the remainder. This is why a collateral assignment effectively overrides the beneficiary designation to the extent of the loan. By contrast, an irrevocable beneficiary must consent before the owner can assign the policy, take a loan, or change the beneficiary — the owner's rights are limited until that consent is given.

Viatical and Life Settlements

An owner may also transfer the policy by selling it. A viatical settlement sells a policy on a terminally or chronically ill insured to a third party for a percentage of the face. A life settlement sells a policy on an insured who is not terminally ill (often an older insured) when coverage is no longer needed. The buyer becomes owner and beneficiary and continues premiums.

Viatical proceeds to a terminally ill insured are generally income-tax-free under the accelerated-death-benefit rules, whereas life-settlement proceeds may produce taxable gain. Both are regulated to protect vulnerable insureds from fraud and unfair pricing.

Accessing Living Values Safely

Pull these access methods into one decision framework. A policy loan borrows against cash value at interest and reduces the death benefit by any unpaid balance, but it is not a taxable distribution as long as the policy stays in force and is not a MEC. A partial withdrawal from a universal life policy reduces cash value and face amount and is taxed only on gain above basis. An absolute assignment permanently transfers ownership, while a collateral assignment pledges the policy as loan security and is limited to the debt.

For terminally or chronically ill insureds, accelerated death benefits and viatical settlements provide cash while living; viatical proceeds to a terminally ill insured are generally income-tax-free, whereas life-settlement proceeds for a healthier insured may create taxable gain.