At 71 Her Old Life Insurance Policy Will Quietly Lapse With a Loan Still on It. She’ll Get a Tax Bill on Money She Never Received

Picture a Form 1099-R showing up in January from an insurance company Carol hasn’t thought about in years. She’s 71. Decades ago she bought a whole life policy, borrowed against it when money got tight, and then put it out of her mind. The form says she took a distribution. She never got a check, but the tax is still hers to pay.

We’ve already covered cashing out a whole life policy and swapping one into long-term care coverage. This one is about a different problem: a policy that ends on its own with a loan still on it. It’s common with older policies, and most owners don’t see it coming.

How a Forgotten Policy Loan Swallows the Whole Policy

A policy loan is money the insurance company lends her, using the policy’s cash value (the savings piece of whole life) as collateral. Nobody makes her pay it back. Unpaid interest just gets added to the balance, so the balance keeps growing year after year.

At some point the loan catches up to the cash value, and when it does, the policy expires, meaning it ends. The insurance company uses the cash value to wipe out the loan.

For tax purposes, that payoff counts as money she received. Only the amount from a fully ended life policy that exceeds the investment in the contract is taxed. The IRS says investment is usually the total of premiums paid, less any refunded premiums, rebates, dividends, or unrepaid loans not included in income. Anything above that shows up on a Form 1099-R and goes on the same Form 1040 lines as pension income, so it’s taxed like regular income.

Courts have backed this. In a 2010 Tax Court case, a man had borrowed $7,136 against a $25,000 policy. Interest drove the balance to $17,203, more than the cash value. The insurance company ended the policy and paid him nothing, and the court still taxed him on a $7,175 distribution.

What Carol’s Lapse Would Cost Her in Real Dollars

Here are some round numbers. Over the years, Carol paid $60,000 in premiums. By the time the policy expires, the loan plus interest will have grown to about $110,000 and eaten up all the cash value. That leaves $50,000 of taxable income, and she doesn’t get a dime of it.

Say she already has $60,000 of taxable income from Social Security and IRA withdrawals. That puts her in the 2026 single bracket of 22% for incomes over $50,400. The expenses drove part of the gain past the line where 24% for incomes over $105,700 starts. Her extra federal tax comes to about $11,086.

Medicare can pile on too, two years later. If the spike raises her income above $109,000, the first single-filer threshold for 2026, her Part B premium goes up by $81.20 a month and Part D by $14.50. That adds about $1,148 a year to the tax bill.

Keeping the Policy Alive Usually Beats Every Other Exit

Life insurance paid out by reason of the death of the insured is generally left out of taxable income. If the policy is still in force when Carol dies, the death benefit pays off the loan and the gain never shows up on a 1099-R. That’s the outcome most people in her position should plan around. Here’s how to get there:

1. Pay the loan interest every year. That stops the balance from growing, so the expiration date stops moving closer, and a few thousand dollars a year is far cheaper than a five-figure tax bill.
2. Pay down part of the loan if she has extra cash. Every dollar she repays widens the gap between the cash value and the loan, which buys the policy more time.
3. Lower the death benefit. A smaller benefit usually costs less to keep in force, so the cash value lasts longer, and heirs get less, but they still get something, and the tax bill stays away.
4. Trade the policy only if the loan comes along. The tax code lets her exchange a life policy for another life insurance contract or for an endowment or annuity contract without paying tax. But under Treasury rules, getting cash or other property in the trade does not come within the provisions of section 1035. Planners point out that a loan wiped out during the exchange is treated as ordinary income to the extent the loan proceeds exceed your basis. Our earlier exchange piece explains how these trades work.

Giving up the policy doesn’t fix anything. The IRS taxes surrender proceeds that exceed the cost of the life insurance policy. She’d face the same gain and also lose the death benefit.

Request This One Document From the Insurer Before Year End

This month, Carol should call the insurance company and ask for an in-force illustration. It projects how the cash value, loan balance, and death benefit will change at current rates. It shows the year the policy is expected to expire. That date tells her how much time she has and what it will cost to keep the policy in force.

The error to avoid is ignoring the annual statement because the policy feels like old news. By the time the expiration notice arrives, her only choices are to come up with cash quickly or take the tax hit.

Contact [email protected] for any questions or corrections.