If you surrender a policy for cash, the amount above your cost (premiums paid, less dividends and other tax-free amounts received) is taxable income, reported to you on Form 1099-R (IRS Publication 525, 2025, checked October 14, 2026).
Start with two numbers: your gain and your need
Before choosing, get an in-force statement from the insurer. You want the cash value, any loan balance, the net cash surrender value, the death benefit and your cost basis.
Your cost basis is generally the premiums you paid, less refunded premiums, rebates, dividends and other amounts you already received tax-free (IRS Publication 525 (2025), Surrender of policy for cash). Gain is what you receive above that cost.
Then ask the bigger question: does anyone still need this death benefit? If a spouse, child or estate would rely on it, cashing out trades a lasting benefit for money now. If no one does, the policy may simply be money that can be put to better use.
The options, one by one
1. Keep it as is
Nothing is taxed, and the death benefit stays. You keep paying premiums, unless dividends can cover them.
2. Take a policy loan
You borrow from the insurer against the cash value. While the policy stays in force and is not a modified endowment contract (MEC), a loan is generally not taxable income (Internal Revenue Code section 72(e)). Unpaid loans and their interest reduce the death benefit (New York Department of Financial Services, Life Insurance Information for Consumers, checked October 14, 2026).
3. Take dividends or a partial withdrawal
Dividends are generally treated as a return of premium, not taxable income (NY Department of Financial Services, checked October 14, 2026), until they exceed what you paid. For a policy that is not a MEC, a partial withdrawal is generally taxed basis first, so cost comes out before gain (IRC section 72(e)(5)). A withdrawal usually lowers the death benefit.
4. Reduced paid-up insurance
You stop paying premiums and the cash value buys a smaller policy that is fully paid. This is one of the standard nonforfeiture options (NY Department of Financial Services, checked October 14, 2026).
5. Extended term insurance
You stop paying and the cash value buys term coverage for a limited time (same source). When that time ends, coverage ends. Ask the insurer how much coverage you would keep and for how many years.
6. A section 1035 exchange
A life policy can be exchanged for another life policy, an annuity or a qualified long-term care contract without tax on the gain (Internal Revenue Code section 1035). The money must go directly between insurers. See our 1035 exchange guide. A loan cancelled as part of the exchange may be taxable (IRS, Instructions for Forms 1099-R and 5498 (2026)).
7. Full surrender
You end the policy and take the net cash value. The gain is taxable as ordinary income, not capital gain (IRS Revenue Ruling 2009-13, Internal Revenue Bulletin, May 26, 2009). The insurer reports it on Form 1099-R (IRS Publication 525, 2025).
The loan trap: a tax bill with no cash
This is the part many owners never hear. If a policy is surrendered or lapses while a loan is outstanding, the loan is paid off from the cash value, and that payoff counts toward what you received. You may incur a substantial tax bill when you surrender, even if you have borrowed out all the cash value (NY Department of Financial Services, checked October 14, 2026).
A policy with a large loan and growing loan interest can lapse on its own. Ask the insurer for an in-force illustration showing how long the policy lasts at the current loan and premium. If it is close to lapsing, decide on purpose rather than letting it happen.
A policy that became a MEC under the 7-pay test (Internal Revenue Code section 7702A) plays by different rules. Loans and withdrawals are taxed gain first, and the taxable part can carry an extra 10% tax before age 59 and a half (IRC section 72(v)).
Selling the policy: life settlements
A life settlement is the sale of your policy to a third party, the life settlement provider, which pays you now, takes over the premiums and collects the death benefit later (NY Department of Financial Services, checked October 14, 2026). A buyer's offer depends on the insured's age and health, the death benefit and the premiums still owed.
Life settlements are regulated by the states, and rules differ. In New York, for example, a broker represents only you and must disclose their pay by the time the contract is signed, and you can cancel the contract until 15 days after you receive the proceeds (same source). Get offers from several providers.
Not all sale proceeds are tax-free, and a sale is taxed differently from a surrender: part can be ordinary income and part capital gain (IRS Revenue Ruling 2009-13, as modified by Revenue Ruling 2020-5, Internal Revenue Bulletin, February 24, 2020). Proceeds may also affect Medicaid or other benefits, and may be reachable by creditors (NY Department of Financial Services).
When cashing out, or keeping it, can make sense
Surrendering can be reasonable when no one needs the death benefit, the gain is small, and you need the money or the premiums strain your budget. Keeping can be reasonable when there is still a need, your health would make new coverage costly, and the policy is in its later years when cash value grows most. See our cash value hockey stick research.
Before acting, have a tax professional run the numbers. Check any new insurer or seller in the NAIC Consumer Insurance Search and with your state insurance department.
A plain example with numbers
All figures are hypothetical. Assume a 72-year-old with $2 million saved owns a $500,000 whole life policy with $250,000 of cash value and a $100,000 policy loan. Premiums paid were $210,000 and $35,000 of dividends were taken in cash, so cost basis is $210,000 minus $35,000, or $175,000. The tax rate is an assumed 22%, used only to show the arithmetic.
| Hypothetical option | Cash to you now | Taxable now | Death benefit left | Watch for |
|---|---|---|---|---|
| Keep as is | $0 | $0 | $400,000 | Loan interest keeps growing |
| Borrow $50,000 more | $50,000 | $0 if not a MEC | $350,000 | Higher lapse risk |
| Full surrender | $150,000 | $75,000 | $0 | About $16,500 tax at 22% |
| Reduced paid-up or extended term | $0 | Ask insurer | Insurer quote | How the loan is handled |
| 1035 exchange to an annuity | $0 | Up to $75,000 if loan is cancelled | $0 | New surrender period |
| Life settlement | Offer varies | Different rules | $0 to your heirs | Must beat $150,000 after fees |
The surrender arithmetic: the owner receives $250,000 of value, $100,000 of which pays off the loan, leaving $150,000 in cash. Taxable gain is $250,000 minus $175,000, or $75,000. At the assumed 22%, tax is about $16,500, so the owner keeps about $133,500 after tax.
Notice that the tax is figured on $75,000 even though only $150,000 of cash arrives. If the loan had grown to $240,000, the owner would get $10,000 in cash and still owe tax on the same $75,000 gain.
Red flags
- A seller who urges you to surrender your old policy and buy a new one before you have compared both side by side.
- A replacement that starts a new surrender charge period on money that is free of charges today.
- Anyone who does not ask whether someone still depends on your death benefit.
- Being told a surrender is tax-free without anyone checking your cost basis.
- A policy loan that has grown close to the cash value, with no one showing you when the policy will lapse.
- Being told to stop paying premiums without hearing about reduced paid-up or extended term options.
- Adding large premiums to an old policy, which could turn it into a modified endowment contract.
- A 1035 exchange pitched without explaining what happens to an existing policy loan.
- A life settlement offer from a single buyer, with no other quotes and no disclosure of broker pay.
- Pressure to sign a sale or replacement quickly, or to skip the cancellation window.
Questions to ask before you sign
- What is my cash value, loan balance, net surrender value and cost basis today?
- Does anyone still need this death benefit, and for how long?
- How long will the policy last at my current loan and premium?
- How much tax would I owe if I surrendered this year?
- Is my policy a modified endowment contract?
- What would reduced paid-up insurance give me, and what would extended term give me?
- How would my existing loan be handled in a 1035 exchange?
- Does the new contract have a surrender charge, and for how many years?
- Would a life settlement offer beat my net surrender value after all fees and taxes?
- Would selling the policy affect Medicaid or other benefits I receive?
- Has a tax professional reviewed the numbers before I sign?
Read This Before You Sign
A one-page checklist: the red flags in annuity and indexed universal life (IUL) sales, and the questions to ask before you sign anything. Before cashing out whole life: cost basis, loan balance, tax on surrender and the seven alternatives to compare. We’ll email it to you.
The Retirement Literacy Foundation is a 501(c)(3) public charity (EIN 41-5062266). General education, not tax, legal or investment advice. Nothing is sold here. Unsubscribe any time.
Sources
- IRS: Publication 525, Taxable and Nontaxable Income, 2025 (checked October 14, 2026)
- New York Department of Financial Services: Life Insurance Information for Consumers (checked October 14, 2026)
- IRS: Revenue Ruling 2009-13, Internal Revenue Bulletin 2009-21 (May 26, 2009)
- IRS: Revenue Ruling 2020-5, Internal Revenue Bulletin 2020-9 (February 24, 2020)
- IRS: Instructions for Forms 1099-R and 5498, 2026 (checked October 14, 2026)
- Internal Revenue Code section 72, via Cornell LII (checked October 14, 2026)
- Internal Revenue Code section 1035, via Cornell LII (checked October 14, 2026)
- Internal Revenue Code section 7702A, via Cornell LII (checked October 14, 2026)
- NAIC: Consumer Insurance Search (checked October 14, 2026)
The Retirement Literacy Foundation is a 501(c)(3) public charity. This page is general education, not tax, legal or investment advice. Nothing is sold here, no product is recommended, and RLF accepts no funding from financial companies. Rules and figures change; each one above shows its source and date. Check anything you plan to act on with your state insurance department or a qualified professional who is not paid on the product.