Keep, reduce, convert or surrender: deciding about an old whole life policy

An old whole life policy usually has five possible futures: keep paying as you have, keep it but change how it is funded, shrink it to a smaller paid-up policy, move its value into something else, or cancel it for cash. No one of those is right for everyone, and the choice often turns on four numbers that sit in a drawer or an online account: the cash value, the loan balance, your cost basis and what the death benefit still does for someone you love. This post walks through gathering those numbers, then through a decision list you can run with your own figures.

Everything below uses general rules and invented numbers. Your contract, your state and your tax situation decide the specifics, so treat the arithmetic as a method to copy, not a price to expect.

Why the question comes up

People return to an old policy for ordinary reasons. The children are grown. The mortgage is paid off or nearly so. Retirement income is fixed and the premium feels heavier than it used to. A dividend notice says the scale was lowered. A relative says the policy is "a terrible investment," and an agent says it is "the best thing you own." Both are describing a financial product that was built to do several things at once, and the honest answer depends on which of those things you still need.

A whole life insurance policy bundles a lifetime death benefit, a guaranteed cash value that grows on a schedule, and, on a participating policy, dividends that are not guaranteed. After decades you may own a large paid-for asset, a policy that is expensive to keep, or something in between. The decision is about the remaining job of the policy, not about whether buying it was a good idea thirty years ago. That money is spent either way.

Step one: gather the facts

Before choosing, collect these in writing from the insurer. Ask the owner of the policy, or whoever has the authority, to request them, and ask for the date each figure is as of.

1. Current cash value and cash surrender value. The cash surrender value is the cash value minus any surrender charge and any loan. Older policies often have no surrender charge, but ask.
2. Loan balance and loan interest rate. A loan is subtracted from the death benefit and from any payout, and unpaid interest compounds. See life insurance policy loans: how they work and what they risk.
3. An how to request and read an in-force illustration. This projects the policy from today under current and guaranteed assumptions, and it shows whether the premium can be reduced, stopped or must continue.
4. Dividend history and the dividend option in use. Dividends may be paid in cash, used to reduce premium, left on deposit or used to buy paid-up additions.
5. Your cost basis. Basis is roughly the premiums you paid, minus dividends received in cash and other tax-free amounts you took out. The insurer can usually report it, and it decides how much of any payout is taxable gain.
6. The nonforfeiture table. This table in the contract shows what a reduced paid-up policy or an extended term period would be worth at each age. See nonforfeiture options: reduced paid-up and extended term.
7. Whether the policy is a modified endowment contract. Most older whole life policies are not, but a policy that was overfunded in its early years may be. Ask.
8. Who owns the policy, who is the beneficiary, and whether anyone holds an assignment. A lender, a trust or an irrevocable beneficiary can have a say in any change.
9. Your own health and insurability today. If you could not buy new coverage, the old policy is more valuable to you than its cash number suggests.

If any of these cannot be found, the insurer's customer service or your state insurance department can help you find the policy and request the records.

A hypothetical policy to work with

Say Carla, 68, bought a $100,000 participating whole life policy at 38. The numbers below are invented to show the method.

• Annual premium: $1,900, paid for 30 years, so $57,000 in total premiums.
• Dividends she took in cash over the years: $16,000. Her basis is therefore $57,000 minus $16,000, or $41,000.
• Current cash value: $52,000. No surrender charge.
• Loan balance: $12,000, taken years ago for a roof.
• Current annual dividend: $1,100.
• Death benefit today: the face amount of $100,000 plus any paid-up additions (none here), less the loan, so $88,000 would be paid at death.

Carla's children are adults with their own incomes. She has a modest pension and Social Security. She is in reasonable health. We will run each path with these numbers.

Path 1: keep it as it is

Carla keeps paying $1,900 a year. Her outlay for an $88,000 net death benefit is $1,900 / 88 = about $21.59 per $1,000 of net death benefit each year. If she uses the $1,100 dividend to reduce the premium, her out-of-pocket cost is $1,900 minus $1,100, or $800 a year, for the same coverage.

That figure alone does not settle it, because the cash value is also tied up in the policy. The honest cost of keeping includes what the $52,000 could earn elsewhere, and the honest benefit includes the guaranteed growth and the fact that the death benefit is certain to be paid if the policy stays in force. Keeping is strongest when someone still depends on the death benefit, when the policy is a planned part of estate liquidity, or when Carla would not qualify for anything comparable.

Path 2: keep it but change how it is funded

Several adjustments leave the policy in force but lighten the burden:

• Use dividends to pay premium. If dividends are currently paid in cash, directing them to premium lowers the cash outlay, though dividends used this way generally are no longer received as cash.
• Stop or reduce premiums with an automatic premium loan or the policy's own cash value. Premiums are paid by borrowing against the policy. This works only while there is room, and it adds to the loan. Ask what the illustration shows.
• Pay down the loan. Even interest-only payments stop the balance from growing. A policy lapsing with a large loan can produce a tax bill larger than the cash received.
• Move to a limited-pay or paid-up status if the contract allows it. Some policies become paid up when the cash value and dividends can carry the premium.

Ask for an illustration of each version. The numbers you want are the age at which each scenario fails, if it does, under the current and the guaranteed columns.

Path 3: reduce it to a smaller paid-up policy

The nonforfeiture options exist so that stopping premiums does not wipe out what you built. The two non-cash choices are:

• reduced paid-up insurance. The cash value buys a smaller whole life policy that needs no more premium and lasts for life.
• extended term insurance. The cash value buys term coverage for the full original face amount, for a limited number of years.

Say Carla's table shows that surrendering $52,000 of value minus the $12,000 loan, leaving $40,000, would buy a paid-up amount of roughly $60,000 if she elected reduced paid-up. (The figure is invented; her real table gives the real number.) She would pay no more premiums, her death benefit would be about $60,000, and the paid-up policy would keep a small cash value. She would give up $28,000 of death benefit compared with Path 1 ($88,000 minus $60,000), and she would save $1,900 a year, or $800 if the dividend was covering part of the cost.

With extended term she would instead keep a death benefit near the face amount for a stated number of years and then nothing. That suits a need that has a known end date, such as a debt, and it is a poor fit for a need that could last as long as she does.

Reducing is often the least regretted compromise when the main problem is the premium rather than the coverage. It keeps something for beneficiaries and ends the payments.

Path 4: convert the value into something else

"Convert" means different things to different people. The three most common versions are:

• A 1035 exchanges: swapping policies without tax into a new life policy or an annuity. Under section 1035 of the tax code, a life policy can be exchanged for another life policy or for an annuity without immediate tax on the gain. This can make sense when the original coverage is no longer needed and the owner wants income or long-term care features. It carries costs: the new product has its own charges, a new surrender period, and, if it is life insurance, a new contestability period and suicide clause. Exchange paperwork is covered in replacement notices and forms, and what the paperwork is meant to protect.
• Converting to a long-term care hybrid. Some policies are built to pay for care from the death benefit or from an annuity-like pool. turning an old cash value policy into long-term care coverage covers how that works, including why it is a replacement and not a rider on your old contract.
• Switching premium paying. Using dividends and paid-up additions to build a fully paid policy over time is a form of internal restructuring and can be asked about without leaving the contract.

Any exchange changes your age, your rate class and the guarantees. Never cancel the old policy until the new one is issued, accepted and in force, and keep the old policy's basis and loan information for the new transfer.

Path 5: surrender it for cash

A surrender ends the coverage and pays the cash surrender value. Carla's arithmetic:

• Cash value: $52,000, no surrender charge.
• The $12,000 loan is repaid from the proceeds. She receives $52,000 minus $12,000, or $40,000.
• Taxable gain is the total received, including the loan that was extinguished, minus her basis: $52,000 minus $41,000 = $11,000, taxed as ordinary income in the year of surrender.

Notice that she receives $40,000 in cash but reports $11,000 of income. If the loan had been $50,000 and the cash value $52,000, she would receive $2,000 and still owe tax on $11,000. That is the trap with heavily loaned policies, covered in more depth in surrendering a life insurance policy: what you get and what it costs. The keep, surrender or sell your policy? can lay out the three paths side by side with your own numbers.

Surrender fits when the need for the death benefit has truly ended, premiums are a strain, and no one depends on the payout. Selling the policy to a third party in a life settlement is a sixth path that can pay more than the surrender value for some older owners. It is also more complex, and it is compared in surrender, sell or keep an unneeded policy: three exits compared.

The decision list

Run these in order. Stop at the first that applies.

1. If someone relies on the death benefit and you cannot replace it (a spouse with limited income, a dependent adult child, an estate that needs liquidity), then keep the coverage in force. Then work on cost: dividends to premium, loan interest, a possible smaller policy through reduced paid-up.
2. If the need is gone and the premium is a strain, and you are in good health, then compare reduced paid-up and surrender. If a smaller lifelong benefit for final expenses is worth keeping, reduced paid-up. If not, surrender after checking the taxable gain.
3. If the need is gone and the policy is healthy but you no longer need the death benefit, then compare surrender, a 1035 exchange to an annuity or care product, and a sale.
4. If you have a serious health condition, then do not cancel until you know whether you could buy anything comparable. The old policy may be the only coverage you can get.
5. If there is a large loan, then price the tax before any surrender or lapse, and ask whether paying interest only, partial repayment or reduced paid-up avoids a taxable event.
6. If the cash value is high and the death benefit is a minor part of the value, then the question is closer to an investment comparison. Compare the policy's after-tax outcome with the alternatives, being honest about the guarantees you would give up.
7. If you are unsure, then keep the policy in force while you gather the facts. Most of these decisions can wait a few weeks, and the information requests are free.

When to get professional help

Bring in a tax professional before any surrender, 1035 exchange or sale, because the gain and the loan interact in ways that surprise people. A fee-only financial planner, who is paid by you and not by commission, can compare the options without a product to sell. If a salesperson proposes replacing the policy, read before you replace a permanent policy: a fifteen-point checklist, and for your state's rules or a complaint about a replacement sale, use your state insurance department. If your estate is large or the policy sits in a trust, an estate attorney should be in the conversation.

Mistakes that cost the most

• Surrendering before checking the loan and the tax.
• Letting the policy lapse by accident because a premium notice went to an old address.
• Replacing an old policy to get a "better" illustration, without comparing guaranteed columns. See four retirees with an old policy: keep, shrink, convert or sell for how this plays out.
• Treating reduced paid-up as a failure. For many people it is the sensible middle path.
• Deciding in a hurry because a salesperson, a deadline or a relative applied pressure.

Key takeaways

• Gather the cash value, loan balance, basis, in-force illustration and nonforfeiture table before choosing anything.
• Keeping, funding differently, reducing, exchanging and surrendering are all legitimate; the right one depends on whether anyone still needs the death benefit.
• A loan changes the math. A surrender can create taxable income larger than the cash received.
• Reduced paid-up and extended term let you stop premiums without surrendering, and the contract's table shows the exact numbers.
• Do not cancel the old policy until any replacement is approved and in force, and use a tax professional or fee-only planner before big moves.