Cost Basis Definition
The Dictionary of Insurance Terms and Definitions
Cost basis is the total amount that a policy owner has invested in his/her life insurance product, less any proceeds. That is the sum of all premiums paid, less withdrawals, dividends, and outstanding policy loans. Penalties or fees paid do not contribute to one's cost basis.
The primary importance of cost basis is the matter complying with government restrictions. Most prominent in this matter are income taxes on interest for cash value life insurance policies. While it is true that life insurance is a tax-advantaged product, if a policyholder withdraws cash or surrenders a policy in excess of his/her cost basis, the excess is vulnerable to income tax (or capital gains tax). (A death benefit, however, is never vulnerable to income tax or capital gains tax.)
Likewise, if a policyholder receives dividends in excess of cost basis, that excess is taxable. Receiving dividends in excess of cost basis may seem impossible, since dividends from participating life insurance are supposed to represent a refund of premium, but if cost basis has already been lowered by cash withdrawal or a policy loan, then a dividend may create taxable income.
The distinction between cost basis and the sum of all premiums is significant in your expectation of proceeds from certain special types of life insurance. ROP life insurance is a special type of term life insurance which provides a refund of all premiums paid if the insured outlives the policy. Variable benefit life insurance refunds the cost basis, in addition to paying an ordinary death benefit, upon the death of the insured.
