Life insurance cost basis

A life insurance policy's cost basis is the policyowner's after-tax investment in the contract — essentially the sum of all premiums paid, minus any dividends received and any prior withdrawals of principal. Because premiums are paid with after-tax dollars, that money comes back to the owner tax-free; only growth above the basis is taxable.

The basis matters most when cash value leaves the policy. If a policy is surrendered, the owner owes ordinary income tax on the amount received above the cost basis. For example, surrendering a policy with $60,000 of cash value and $45,000 of premiums paid produces $15,000 of taxable gain. Partial withdrawals from a standard (non-MEC) policy follow first-in, first-out (FIFO) treatment: the owner recovers basis first, tax-free, and only amounts beyond the basis are taxed.

Several transactions interact with basis in ways exams like to test. Policy dividends are treated as a tax-free return of premium and reduce basis rather than creating income. Policy loans are generally not taxable while the policy stays in force. And the death benefit itself is received income tax-free by the beneficiary, so basis calculations matter for living benefits, not death proceeds.

State life insurance licensing exams test cost basis within the taxation of life insurance products — expect questions asking you to compute the taxable gain on a surrender, apply FIFO treatment to a withdrawal, or recognize that dividends reduce basis.