At 71, He Plans to Drop a Whole Life Policy He No Longer Needs. Cashing Out Could Trigger Taxes, While a 1035 Swap to Long-Term Care Coverage May Avoid Them

Giving up a whole life policy you no longer need can look straightforward, until you realize how much of the accumulated gain the IRS may claim. There is a lawful exchange that can avoid that tax hit, but only if it is handled correctly.

The annual statement for a whole life policy he bought decades ago shows a rising cash value, and he wonders why he still keeps paying premiums. The children are grown and the mortgage is paid off. The death benefit was meant to protect a family that no longer needs that protection, so he plans to stop the payments at 71 and wants to know what to do with the cash value.

Many retirees reach this point. Households headed by someone 70 or older held 33.6% of U.S. household net worth in the second quarter of 2026, and many people in that generation bought whole life insurance as a savings vehicle. Years ago, a caller to The Clark Howard Podcast asked a question that still comes up often: “Are there companies that kind of specialize in that transition between a life insurance policy and long-term care?”

Why a Direct Surrender Can Trigger a Full Tax Bill

The short version is that cashing in a policy can be expensive from a tax standpoint. Any amount received above the policy’s cost is taxable. That cost, known as the contract’s investment, is generally the premiums paid, minus any refunded premiums, rebates, dividends, or unpaid loans that were not already counted as income. The gain is reported on lines 5a and 5b of Form 1040, the same area used for pension income, and it is taxed as ordinary income at the same rates as wages under 26 U.S.C. § 72(e).

Old policy loans can make the result worse. The insurer repays itself from the cash value first, so the check may be small even though Form 1099-R shows the full proceeds and the taxable amount. A large gain can also raise Medicare costs. In 2026, Part B is $202.90 a month for individuals with modified adjusted gross income up to $109,000 ($218,000 joint). Above that, it starts at $284.10. IRMAA surcharges like that are among the retirement expenses covered in a free Medicare guide.

How a 1035 Exchange Can Shift the Value Without Immediate Tax

Under 26 U.S.C. § 1035(a)(1), gain is not recognized when a life insurance policy is exchanged for another life policy, an endowment, an annuity, or a qualified long-term care insurance contract. The long-term care option was added by the Pension Protection Act of 2006 and applies to exchanges made after Dec. 31, 2009. Hybrid policies also qualify, since a hybrid is a life policy or annuity with long-term care coverage attached as a rider, and the law still treats it as life insurance or an annuity (§ 1035(b)(2) and (b)(3)).

No tax is due because the money goes into a new contract instead of being paid out to him. His basis, meaning the amount he has paid in, carries over to the new policy (§ 1035(d)(2)). The untaxed gain simply moves into the new contract along with the rest of the value.

Several requirements keep the exchange tax-free. The funds must move directly from the old insurer to the new one. If he takes the money personally and then reinvests it, the nonrecognition rules do not apply. The new contract generally has to insure the same person, and the owner usually remains the same. If any cash is paid back to him during the exchange, that portion can be taxable (§ 1035(d)(1)).

Health, Fees and Premiums Can Still Make the Deal Unattractive

1. Medical underwriting. At 71, he will likely need to pass a health review to qualify for long-term care coverage. A recent diagnosis can increase the price or lead to a denial.
2. Surrender charges. The old policy may still impose a fee for ending it early, and that reduces the amount that can move over. The policy statement should show it.
3. Premium increases. Traditional long-term care policies with annual premiums can later become more expensive. A hybrid funded by one lump sum from the exchange avoids ongoing bills.
4. Tax on benefits. Benefits from a qualified contract are treated as reimbursement for actual medical care costs. Policies that pay a flat daily amount are tax-free up to a per-day cap of $175, adjusted for inflation each year, or up to actual care costs if those are higher (§ 7702B(d)).

The tradeoff is that the death benefit disappears. That may matter if a spouse would need the payout or if leaving money to heirs is important. It matters much less when the children are financially independent.

Less Expensive Options to Review First

Reduced paid-up insurance stops premiums and converts the policy into a smaller, fully paid death benefit with no tax due. Some policies can also use cash value or dividends to pay the premiums until the value runs out. Selling the policy to a third party, known as a life settlement, is taxed differently from surrendering it. It is treated like selling property, and the law does not allow the policy’s insurance charges to reduce basis (26 U.S.C. § 1016(a)(1)(B)).

For many people in his situation who can qualify medically and do not depend on the death benefit, the exchange is the better choice than surrendering the policy. If a spouse still needs protection, reduced paid-up coverage is often the better fit.

One Key Figure to Request Before Deciding

Before signing anything, ask the insurer in writing for the policy’s investment in the contract, the cash surrender value, and any loan balance. If the cash value is close to the contract’s cost, surrendering may create little tax, and the decision comes down to whether he wants the coverage. If the cash value is much higher, the exchange is what prevents that gain from being taxed.

The mistake to avoid is taking the check and then using it to buy long-term care coverage. The IRS treats that as cashing out and reinvesting, which does not qualify for tax-free treatment, so the gain becomes taxable.