4.4 Policy Loans, Withdrawals, and Assignments

Policy Loans, Withdrawals, and Assignments

The living benefits of permanent insurance include the owner's right to borrow against cash value, take withdrawals (in flexible-premium contracts), and assign the policy as collateral or transfer ownership. The exam tests how each affects the death benefit, the tax treatment, and the special MEC rules.

Policy Loans

The owner may borrow up to the available cash value at a contractually stated or variable interest rate. Key rules:

• The insurer cannot refuse a loan request (it is a contractual right) and may delay payment up to 6 months except for loans to pay premiums.
• Loans are not taxable while the policy stays in force, because they are debt, not income.
• Unpaid loan principal plus accrued interest is deducted from the death benefit if the insured dies, and from cash value at surrender.
• If outstanding loans plus interest ever exceed the cash value, the policy lapses unless the owner repays enough to keep it in force.

Loan Interest and Direct vs. Indirect Recognition

Policy loan interest may be fixed or variable. Insurers credit borrowed cash value differently: under direct recognition the borrowed portion earns a different (often lower) dividend or interest rate, while under non-direct recognition the full cash value continues earning as if no loan existed. The exam point is that an unpaid loan quietly erodes both cash value and the death benefit, and a policy lapses if loan plus interest overtakes the cash value.

Loans vs. Withdrawals Side by Side

Worked Example: MEC 7-Pay Test

Assume the net level annual premium to pay up a policy in seven years is $8,000. If the owner pays $12,000 in year one, cumulative premiums ($12,000) already exceed the cumulative 7-pay limit ($8,000), so the contract fails the 7-pay test and becomes a MEC. From that point, any loan or withdrawal is taxed LIFO (gain first) with a 10% penalty before age 59 1/2. Death proceeds, however, stay income-tax-free. Remember: once a MEC, always a MEC, and the taint follows the contract through a 1035 exchange.

Assignment Notice Requirement

For any assignment to bind the insurer, the owner must give written notice to the company; the insurer does not vouch for the assignment's legal validity. In a collateral assignment, only the lender's outstanding debt is paid first from proceeds and the named beneficiary takes the rest, whereas an absolute assignment transfers every incident of ownership permanently.

Six-Month Deferral and the Spendthrift Limit

Insurers may defer a cash-value loan or surrender for up to six months (except a loan to pay premiums), a holdover from liquidity-protection rules. Note also that a spendthrift clause protects settlement proceeds from a beneficiary's creditors but does not protect cash value the living owner can freely reach — the owner's loans and withdrawals are fully exposed to the owner's own creditors.

Withdrawals (Partial Surrenders)

Universal life and other flexible contracts allow partial withdrawals from the account value. Unlike loans, withdrawals are not repaid and permanently reduce both the cash value and (usually) the death benefit. Tax treatment normally follows FIFO (first-in, first-out): withdrawals come out of basis (premiums paid) first and are tax-free until withdrawals exceed total premiums, after which the gain is taxable. This is the opposite of annuity LIFO taxation.

The MEC 7-Pay Test

A Modified Endowment Contract (MEC) is a life policy funded so quickly it fails the IRS 7-pay test - the cumulative premiums in the first seven years exceed the net level premiums needed to pay the policy up in seven years. Consequences of MEC status:

• Distributions (loans AND withdrawals) are taxed LIFO - taxable gain comes out first.
• A 10% penalty applies to taxable amounts taken before age 59 1/2.
• The death benefit remains income-tax-free - MEC status only affects living distributions.

Trap: Once a MEC, always a MEC; the status cannot be reversed and carries to any policy received in an exchange.

Worked Example: Loan Impact on Death Benefit

A $250,000 whole life policy has $40,000 cash value. The owner borrows $30,000 and dies before repaying, with $1,500 of accrued loan interest. The beneficiary receives:

• $250,000 face - $30,000 loan - $1,500 interest = $218,500

The loan is never taxable to the owner because the policy stayed in force, but it permanently reduced the benefit by the outstanding balance.

Assignments

In a collateral assignment, the lender (assignee) is paid first from the death benefit only up to the outstanding debt, and the named beneficiary receives the remainder. The owner keeps all other rights. In an absolute assignment, the new owner gains all incidents of ownership - the right to name beneficiaries, borrow, surrender, and assign. The insurer must be notified in writing; insurers do not guarantee an assignment's validity.