To encourage investing, the IRS doesn't tax the money you pay into an asset, known as your cost basis. Otherwise, the money you pay in would be taxed twice. This rule is also true for permanent life insurance, which combines an investment account with your insurance coverage. Understanding your policy's cost basis will help you determine how much money you can take out of your policy without owing taxes.
Permanent life insurance policies offer something called cash value. This is money you can take out and spend while you are alive. There are two main investment categories of permanent life insurance. Whole life insurance gives a guaranteed, fixed rate of return. Your cash value grows steadily each year and you can never lose money. Variable life insurance invests your money in the stock market. In these policies, your return will be different each year. You will have some years where you make big gains but others years you could lose money.
Your life insurance cash value is a combination of your insurance premiums and your investment gains. The cost basis in the policy is the sum of all your insurance payments. If your cash value balance is higher than the amount you paid in premiums, the remaining money represents your taxable gains. For example, if you paid $20,000 in insurance premiums and have a cash value balance of $25,000, you have a cost basis of $20,000 and the other $5,000 is from your gains.
You can take out some or all of your cash value anytime you want. If you contact your insurance company, it will send you a check within a few days. When you make a withdrawal, IRS rules state that your cost basis gets taken out first. This means your withdrawals are tax-free until you've taken out all the money you've paid in premiums. If you take out your investment gains, the gains are taxable as income for that tax year.
Your life insurance policy's cost basis only matters for when you take out cash value. If you die while insured and your heirs receive a death benefit, your cost basis is not a factor for taxes. This is because the IRS doesn't charge income tax on the payout of life insurance death benefits. Since your heirs would not owe income tax on this payout no matter what, they don't need to know what the remaining cost basis is in your policy.
Dylan Armstrong specializes in insurance, investing and retirement planning. He has also worked as a life and health insurance salesman and holds a Bachelor of Science in finance from Boston College.