By Marc Gilman
(800) 927-9326 |
If you’re holding a variable universal life (VUL) policy that isn’t performing the way it was illustrated decades ago, you’re far from alone. Many VUL contracts sold in the late 1990s and early 2000s were illustrated at optimistic hypothetical growth rates. When actual market and crediting results came in lower, the gap between what was promised and what materialized left many policyholders facing rising costs, shrinking cash value, and real questions about whether the policy will even stay in force.
The good news: a underperforming policy isn’t an all-or-nothing decision. Before reaching for the phone to surrender it, it’s worth understanding the full menu of options — because the wrong move can trigger a tax bill, and the right move often costs nothing but a little homework.
Key Takeaways
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An underperforming VUL policy has more than one path forward — surrender is rarely the best first move.
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The starting point for every option below is the same: request a current in-force illustration, run at both current and guaranteed assumptions.
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Reducing the death benefit, adjusting premiums, or using policy loans strategically can often keep coverage in force without new out-of-pocket cost.
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A 1035 exchange lets you move the policy’s value into a new contract without triggering current income tax, if the death benefit is no longer needed.
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Surrendering the policy outright is usually the costliest option once gain, ordinary income tax, and lost coverage are weighed together.
What Does It Mean When a Variable Life Policy Is “Underperforming”?
A VUL policy’s cash value depends on how its underlying subaccounts perform, net of the policy’s own internal charges — cost of insurance, mortality and expense risk fees, and fund-level expenses. Early VUL contracts were often illustrated using hypothetical gross returns of 8% or more. When actual net returns land closer to 3–5% over long stretches, particularly in bond-heavy or conservative allocations, the policy’s cash value can fall well short of what was originally projected.
The consequence isn’t always immediate. Cost of insurance charges typically rise with the insured’s age, and if the policy also carries an outstanding loan, unpaid loan interest can capitalize into the loan balance year after year. Over time, this combination can accelerate a policy toward lapse — sometimes years earlier than the original illustration ever suggested.
What’s the First Step Before Making Any Decision?
Before choosing among the options below, request a current in-force illustration from the carrier. Ask specifically for two versions: one at the policy’s current assumed rate, and one stress-tested at the contract’s guaranteed minimum rate with maximum charges applied. This second version shows the worst-case scenario — the earliest point the policy could lapse if performance stays weak and no changes are made.
This single document is the foundation for every decision that follows. Without it, any disposition decision is a guess.
Can You Keep the Policy Without Paying More Out of Pocket?
If the goal is simply to keep coverage in force without increasing premium payments, a few options are worth exploring:
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Reduce the death benefit. Most VUL contracts allow a reduction in the death benefit, which lowers the net amount at risk and, in turn, the monthly cost of insurance charge. This can meaningfully slow the rate at which the policy’s cash value is drawn down.
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Adjust premium timing or amount. Flexible-premium contracts allow changes to how much and how often premiums are paid. Paying closer to the illustrated target premium, where affordable, can extend the policy’s runway.
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Use dividends or cash value strategically, if applicable. Some policies allow charges to be covered from existing cash value rather than new premium dollars, though this accelerates cash value depletion and should be modeled against the in-force illustration first.
Each of these preserves the original death benefit purpose of the policy, just at a lower cost structure or a smaller face amount.
What If You No Longer Need the Death Benefit?
If the original reason for the policy — a mortgage, dependent children, a business obligation — no longer applies, it may be time to consider whether life insurance is still the right vehicle at all.
A Section 1035 exchange allows a policyholder to move a life insurance contract’s value into a new life insurance policy, an annuity, or a qualifying long-term care policy, without triggering current income tax on any gain in the process. This can be a useful way to redirect the policy’s remaining value toward a different need — such as long-term care protection — without a taxable event.
It’s worth noting that exchanging a decades-old policy into a new one isn’t automatically the right move. A policy held for many years has already absorbed most of its front-loaded costs; a brand-new contract starts that cost structure over again. Any exchange should be compared against simply keeping the existing policy, adjusted as described above.
One caution that applies to a 1035 exchange as much as to any large lump-sum payment into an existing policy: funding a policy too heavily, too quickly, can trigger Modified Endowment Contract (MEC) status. The test looks at cumulative premiums paid during the first seven years after issue — or during the seven years following a “material change” to the policy, which a 1035 exchange or a benefit increase can sometimes trigger. Once a policy is classified as a MEC, withdrawals and loans are taxed as ordinary income to the extent of any gain, and a 10% penalty can apply if the policyholder is under age 59½. Any exchange or large premium payment should be run past the carrier’s underwriting team first to confirm it won’t cross this line.
Is There a Way to Access Cash Without Surrendering the Policy?
If the immediate need is cash rather than a policy decision, two options avoid a full surrender:
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Withdrawal to basis. Under current tax rules, life insurance withdrawals are treated as coming out of your premium basis first, meaning withdrawals up to the total premiums paid are generally received income tax-free.
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Policy loans. Amounts borrowed against a policy’s cash value are not treated as taxable income while the policy remains in force. However, loan interest that isn’t paid out of pocket typically capitalizes into the loan balance, and if a loan balance grows to equal or exceed the policy’s cash value, the policy can lapse — potentially triggering a large taxable gain in a year with no cash on hand to pay it. The same exposure applies even if the policy doesn’t lapse but is later surrendered voluntarily: if the outstanding loan balance plus the cash surrender value exceeds the total premiums paid into the policy, the excess is generally taxable as ordinary income at the time of surrender.
Both of these preserve the death benefit and avoid an immediate tax event, but neither is free — each reduces the policy’s staying power and should be modeled against the guaranteed-rate illustration before proceeding. It’s also worth weighing other sources of liquidity against a policy loan or withdrawal before deciding — home equity, a 401(k) loan, or a personal loan may compare favorably once the policy’s own long-term cost is factored in.
When Does Surrendering the Policy Make Sense?
Surrendering a policy outright — turning it in for its cash surrender value — is sometimes the right call, but it comes with real costs that are easy to underestimate:
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Any gain (cash surrender value above total premiums paid) is taxed as ordinary income in the year of surrender, all at once.
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A large one-time gain can push a retiree into a higher tax bracket, increase the taxable portion of Social Security benefits, and trigger higher Medicare Part B and Part D premiums two years later through the IRMAA surcharge.
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The death benefit — often several times the cash value — is permanently given up.
Surrender is most defensible early in a policy’s life, before most of its costs have already been absorbed, or when there’s no remaining need for coverage and the tax consequences have been fully modeled and accepted in advance.
What About Life Settlements?
For policyholders who no longer need or want the coverage, and whose policy has a substantial face amount, a life settlement — selling the policy to a third-party investor for more than its cash surrender value but less than its death benefit — is worth exploring as an alternative to surrender or lapse. This option is generally only available for larger policies and depends on the insured’s age and health profile. The tax treatment of settlement proceeds is more complex than a standard surrender, typically involving a mix of basis recovery, ordinary income, and capital gain, so this route should always be reviewed with a tax professional before proceeding.
Where Does Insurance Planning Fit In?
Every option above involves trade-offs between cost, coverage, taxes, and flexibility — and the right answer depends entirely on your original purpose for the policy, your current financial picture, and what the in-force illustration actually shows. Insurance planning isn’t just about buying a policy; it’s about periodically reviewing what you already own to make sure it’s still doing the job it was bought to do. A policy that made sense in 2001 may need a fresh look in 2026, particularly if it’s been quietly running on autopilot for two decades.
What To Do Next
If you’re holding a variable universal life policy that isn’t performing as expected, don’t make a decision based on the surrender value alone. Request a current in-force illustration, and talk through your options with a licensed professional who can walk through the tax and coverage trade-offs specific to your policy and your goals.
Contact Gilman Agency at (800) 927-9326 or to schedule a policy review.
Sources: This article draws on general provisions of the Internal Revenue Code governing life insurance taxation, including Section 1035 exchanges, Modified Endowment Contract rules, and the tax treatment of policy loans and withdrawals, along with publicly available insurer prospectus disclosures and educational materials describing variable universal life contract mechanics. Individual policy terms vary by carrier, contract form, and issue date; always review your specific policy documents and in-force illustration before making any decision.
This article is for general informational purposes only and does not constitute tax, legal, or financial advice. Insurance products and their features vary by state and carrier. Consult a licensed insurance professional and a qualified tax advisor before making changes to an existing life insurance policy.
