Question 45

The cost basis of the policy is exempt from taxation.

When a life insurance policy is surrendered for its cash value, the cost basis of the policy is generally exempt from taxation, meaning that the amount paid into the policy is not subject to tax upon surrender.

A) The insurer retains the cost basis.

This option is incorrect because the cost basis refers to the amount the policyholder has invested in the policy, not something retained by the insurer. Upon surrender, the policyholder is concerned with the tax implications of their cash value, not the insurer's retention of the cost basis.

B) The entire surrender value is taxable.

This option is incorrect as well. While any amount received in excess of the cost basis may be taxable, the cost basis itself is exempt from taxation, meaning that not the entire surrender value is taxable.

C) The insured receives only the cost basis.

This statement is misleading and incorrect. Upon surrendering a policy, the insured typically receives the cash value, which may exceed the cost basis. The cost basis is not the only amount received but rather a component that affects the tax implications.

D) The cost basis of the policy is exempt from taxation.

This option is correct. When a life insurance policy is surrendered for its cash value, the cost basis—the total amount paid into the policy—is not taxable. Only the portion of the cash value that exceeds the cost basis may be subject to taxes.

Conclusion

The correct answer highlights that the cost basis of a life insurance policy is exempt from taxation upon surrender, which is a crucial aspect of tax law related to life insurance. Options A, B, and C misinterpret the tax implications of surrendering a policy, failing to recognize the distinction between the cost basis and taxable gains. Thus, option D clearly stands out as the accurate representation of the cost recovery rule in this context.