4.4 Policy Loans, Withdrawals, and Assignments

Policy loans

The policy loan provision lets the owner borrow against the available cash value at a stated fixed rate or a variable (indexed) rate disclosed in the contract. Key points the exam tests:

• A loan is not taxable while the policy stays in force — the owner is simply borrowing against their own equity, so there is no realized gain.
• The owner is never required to repay a policy loan on a fixed schedule, but unpaid principal and accrued interest are deducted from the death benefit or the surrender value.
• If the loan plus interest ever exceeds the cash value, the policy can lapse; at that point any gain becomes taxable, which can create an unwelcome tax bill on a policy that paid nothing out.
• Insurers may defer granting a policy loan for up to 6 months (except a loan to pay a premium), a holdover from the delay clause designed to protect insurer liquidity.

Automatic premium loan and withdrawals

The automatic premium loan (APL) rider prevents unintended lapse: if a premium is unpaid at the end of the grace period, the insurer automatically borrows from cash value to pay it. APL is an optional provision the owner elects.

Withdrawals (partial surrenders) apply mainly to universal life. Unlike a loan, a withdrawal permanently reduces cash value and usually the death benefit. Tax treatment normally follows FIFO (first-in, first-out): withdrawals come from cost basis first (tax-free), then gain (taxable) — unless the policy is a MEC.

Modified Endowment Contracts and the 7-pay test

A Modified Endowment Contract (MEC) is a life policy that fails the 7-pay test — it was funded faster than a level annual premium would have paid it up in 7 years. Overfunding to build tax-sheltered cash value triggers MEC status.

MEC consequences (living distributions only — death benefit stays tax-free):

• Loans and withdrawals are taxed LIFO — taxable gain comes out first.
• A 10% penalty applies to taxable distributions taken before age 59½.
• Once a MEC, always a MEC; a 1035 exchange carries the taint forward.

Worked example: a policy with $40,000 cash value and $25,000 basis is a MEC. A $10,000 loan is fully taxable (gain-first), and if the owner is 50, a $1,000 (10%) penalty also applies. The same loan on a non-MEC policy would be tax-free while in force.

Assignments

An assignment transfers some or all of the owner's rights to another party. The exam tests two types:

• Absolute assignment — a complete, permanent transfer of all ownership rights to a new owner (for example, gifting a policy to an adult child, selling it in a life settlement, or transferring it to an ILIT). The assignee becomes the owner and controls beneficiary changes, loans, and surrender.
• Collateral assignment — a partial, temporary transfer naming a creditor (often a bank) to secure a debt. The lender is paid first from proceeds up to the outstanding debt; the balance passes to the named beneficiary. It is common to secure a business loan and is released once the debt is repaid.

The owner must notify the insurer of an assignment, but the insurer is not required to approve it and assumes no responsibility for its validity. An irrevocable beneficiary must consent before any assignment. Traps to avoid: a collateral assignment does not change the beneficiary, and an absolute assignment is permanent — never confuse it with a temporary loan pledge.

Worked Example: The 7-Pay MEC Test

A whole life policy has a 7-pay limit of $9,000/year. If the owner pays $12,000 in year one, cumulative premiums ($12,000) exceed the cumulative 7-pay limit ($9,000), so the contract becomes a MEC. Once a MEC, always a MEC. The consequence: living distributions (loans, withdrawals) are taxed LIFO (gain first) and a 10% penalty applies before 59 1/2 — but the death benefit stays income-tax-free.

Absolute vs. Collateral Assignment

An absolute assignment transfers all ownership rights permanently (e.g., a gift or sale of the policy). A collateral assignment transfers rights only temporarily and partially — typically to a lender, who is repaid from the death benefit before the beneficiary, with any excess going to the named beneficiary. Banks routinely take collateral assignments to secure a loan; the borrower keeps ownership once the debt is repaid.

Loans vs. Withdrawals Side by Side

Key trap: in a non-MEC, withdrawals come out basis first (FIFO) and loans are not taxed while the policy stays in force. In a MEC, both are taxed gain first (LIFO) with a possible penalty. The death benefit is income-tax-free either way.