Question 87

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 exempt from taxation. This means that the amount the policyholder initially invested in the policy is not subject to income tax upon surrender.

A) The insurer retains the cost basis.

This option is incorrect because the cost basis refers to the amount the policyholder paid into the policy, not something retained by the insurer. When a policy is surrendered, the policyholder is entitled to the cash value minus any applicable loans or withdrawals, while the insurer does not retain the cost basis for tax purposes.

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 not taxable at the time of surrender. Thus, the entire surrender value is not subject to taxation, only the portion that exceeds the cost basis.

C) The insured receives only the cost basis.

This option is incorrect because when a life insurance policy is surrendered, the insured typically receives the cash value, which may be more than just the cost basis. The insured does not receive only the cost basis, as the cash value reflects the total value accumulated in the policy.

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

This option is correct because when a policy is surrendered, the cost basis is not subject to taxation. The policyholder can receive the cash value without having to pay taxes on the amount they originally invested in the policy.

Conclusion

The correct answer is D because it accurately reflects the tax treatment of the cost basis when a life insurance policy is surrendered. Options A, B, and C fail to recognize the distinction between the cash value received and the tax implications of the cost basis, while D correctly states that the cost basis is not taxable upon surrender.