4.4 Policy Loans, Withdrawals, and Assignments

Policy Loans

The policy loan provision lets the owner of a cash-value policy borrow against the policy's cash value, using the cash value as collateral. The insurer must offer this provision on permanent policies once cash value exists. Loans are not taxable when taken (they are debt, not income) on a non-MEC policy, and the owner is never required to repay during life — but any outstanding loan plus accrued interest is deducted from the death benefit if the insured dies, and from the surrender value if the policy is surrendered.

Interest is charged at either a fixed rate stated in the policy or an adjustable (variable) rate tied to a published index, as the contract specifies. If unpaid loan interest plus the loan exceeds the cash value, the policy can lapse, which may trigger a taxable event. The insurer may defer a loan request for up to six months (except a loan to pay premiums).

Policy loans have unique advantages worth knowing for the exam. The owner needs no credit check and faces no fixed repayment schedule, since the cash value secures the debt. The borrowed funds are the owner's own accumulated value, so the loan itself is not income. However, the cash value typically keeps earning interest or dividends while loaned (a feature called a non-direct-recognition versus direct-recognition approach, depending on the insurer), and unpaid loan interest is added to the loan balance, compounding the risk of lapse if neglected.

Withdrawals (Partial Surrenders)

Universal life and some other flexible policies allow partial withdrawals (partial surrenders) of cash value, which differ from loans. A withdrawal is not borrowed; it permanently removes money from the policy and usually reduces the death benefit dollar-for-dollar. Withdrawals are generally taxed under FIFO (first-in, first-out) on a non-MEC policy: amounts up to the cost basis (premiums paid) come out tax-free first, and only amounts above basis are taxable.

By contrast, a policy loan does not reduce cost basis and is not taxed while the policy stays in force. This FIFO-versus-loan distinction is a high-frequency exam point. Withdrawals may also incur surrender charges during the surrender-charge period.

The MEC Trap (7-Pay Test)

A Modified Endowment Contract (MEC) is a life policy that was funded too quickly and fails the federal 7-pay test — meaning cumulative premiums in the first seven years exceed the limit that would pay the policy up with seven level annual premiums. Once a contract is a MEC, it is always a MEC, and the favorable tax treatment of loans and withdrawals is lost.

Worked example: A MEC has $30,000 cash value and a $20,000 basis. The owner takes a $12,000 loan. Under LIFO, the $10,000 of gain is taxed first as ordinary income, and because the owner is 50, a 10% penalty ($1,000) also applies. The same loan on a non-MEC would be tax-free.

Assignments

An assignment transfers some or all of the owner's policy rights to another party. The owner must notify the insurer; the insurer is not responsible for the validity of an assignment but must record it.

• Absolute assignment: a complete, permanent transfer of all ownership rights to a new owner (e.g., gifting a policy or a viatical sale). The assignee becomes the new owner.
• Collateral assignment: a partial, temporary transfer used to secure a debt (often a bank loan). The lender is repaid from proceeds up to the debt amount, and any remainder goes to the named beneficiary. Ownership rights otherwise remain with the original owner.

A collateral assignee's claim is limited to the loan balance, unlike a beneficiary designation. An irrevocable beneficiary's written consent is required before the owner may assign the policy.

Keep assignment distinct from a beneficiary change: assignment transfers ownership rights (the power to borrow, surrender, name beneficiaries), while a beneficiary change only redirects who receives proceeds and leaves ownership intact. In a viatical or life settlement, a terminally or chronically ill owner makes an absolute assignment of the policy to a third-party buyer for a lump sum greater than the cash value but less than the face amount; the buyer then becomes owner and beneficiary and pays remaining premiums. Producers must understand these transfers because they carry suitability and disclosure obligations.

Finally, tie the loan and withdrawal rules back to the death benefit. Any outstanding policy loan plus accrued interest reduces the proceeds paid at death, and a prior withdrawal permanently lowers the face amount on most universal life designs. So a client who has aggressively tapped a policy during life may leave heirs far less than the original face. A diligent producer reviews loan balances at policy review time, warns when the loan approaches the cash value (lapse risk), and explains that surrendering a policy with a gain — or letting a loan-burdened policy lapse — can convert a tax-free benefit into taxable income.