Getting approval on a loan can sometimes depend on one or two very important issues. For example, lenders often ask borrowers the question, “How will this loan be repaid in the event of your death?” Your answer may be to suggest assigning your life insurance policy.* This useful feature of a life insurance contract can help provide the necessary comfort level and security for a lender.
You can freely assign your life insurance policy unless some limitation is specified in your contract (your insurance company can furnish the required assignment forms). Through an assignment, you can transfer your rights to all, or a portion, of the policy proceeds to an assignee. The extent to which these rights are transferable depends on the assignment provisions in the policy, the intention of the parties as expressed in the assignment form, and the actual circumstances of the assignment.
In general, no interest deduction is allowed when the indebtedness is used to purchase or carry a life insurance contract. However, there is an exception that will allow the interest deduction as long as the indebtedness is incurred in connection with a trade or business.
Types of Assignments
There are two types of conventional insurance policy assignments:
1. An absolute assignment is normally intended to give the assignee every right in the policy that you possessed prior to the assignment. When the transaction is completed, you have no further financial interest in the policy.
The terminology of absolute assignments differs from contract to contract. In essence, it states that you transfer all rights, title, and interest in the policy to the assignee. Some insurance companies use an “ownership clause” to accomplish this transfer.
2. A collateral assignment is a more limited type of transfer. It is a security arrangement to protect the assignee (lender) by using the policy as security for repayment. After the indebtedness is repaid, the assignee releases his or her interest in the policy.
In other words, the assignee will revert to you the rights transferred by the assignment. Under the usual procedure, if the collateral assignment is still in force at your death, the assignee informs the insurance company of the remaining indebtedness including interest and receives that amount in a lump sum. Any excess proceeds are then payable to your named beneficiary in accordance with the beneficiary designation in your policy.
To fully protect the assignee, notice must be given to the life insurance company that the assignment has been made. If a company with no notice of assignment makes payment of the proceeds to another assignee or to a named beneficiary, the insurance company cannot be made to pay a second time.
Some typical policy provisions concerning assignments may include the following:
1. The assignment will not be binding until the original, or a duplicate thereof, is filed at the insurance company’s home office.
2. The insurance company assumes no obligation as to the effect, sufficiency, or validity of the assignment.
3. The assignment is subject to any indebtedness to the insurance company on the policy.
Thus, it is important to ensure that an assignment is made properly, regardless of whether it is absolute or collateral.
*Although loans generally are not taxable, there may be tax consequences if the policy lapses or is surrendered (even as part of a 1035 exchange) with a loan or assignment outst anding. The taxable income from the surrender, 1035 exchange, or lapse of the policy may exceed the cash proceeds received from it. If the policy is a modified endowment contract (MEC), pre-death distributions from the policy, including loans and assignments, are taxed on an income-first basis, and there may also be a 10% federal income tax penalty for distributions prior to age 59½.
Pursuant to IRS Circular 230, we are providing you with the following notification: The information contained in/on this article, illustration is not intended to ( and cannot) be used by anyone to avoid IRS penalties. This [document, brochure, article, illustration, flyer, website] supports the promotion and marketing of life insurance. You should seek advice based on your particular circumstances from an independent tax advisor.
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This article appears courtesy of Karl Susman. Karl Susman is a representative of the New Engl and Life Insurance Company. He focuses on meeting the individual insurance and financial services needs of people on the West Coast. You can reach Karl at the office at (424) 785-4337. New Engl and Life Insurance Company, 501 Boylston Street, Boston, MA 02116