Figuring your cost basis in a cash value policy before any withdrawal

Before you take a dollar out of a cash value policy, you need one number: your basis. It is the amount of money you put in that the tax law will not tax a second time, and it decides whether a withdrawal is free of income tax, whether a surrender produces a taxable gain, and how large that gain is. This post is a worksheet. You gather four kinds of figures, do a short run of addition and subtraction, and finish with a basis you can compare against the insurer's own statement.

Everything below is general education about how the rules work in principle. Your policy, your riders and your history of loans and withdrawals can change the result, so treat the answer as a draft to confirm with the insurer and a tax professional.

What basis means, and why it moves

Basis, which the tax code calls your "investment in the contract," is generally the premiums you have paid, reduced by amounts you have already received that were not taxed. The cost basis glossary entry has the short definition. The how cash value is taxed: withdrawals, loans and surrenders guide explains why the number matters: on an ordinary policy that is not a modified endowment contract, a withdrawal is generally treated as coming from basis first, so you can take out up to your basis without income tax. A surrender or lapse is different. There the taxable gain is everything you are treated as receiving, including any loan that is wiped out, minus basis.

Basis is not the same as any of these numbers, which people often confuse with it:

• The cash value on your statement. That is what the policy is worth inside the contract. Basis is what you contributed.
• The surrender value. That is cash value after surrender charges and loans. See cash surrender value.
• The death benefit. The death benefit to a named beneficiary is generally free of income tax and has nothing to do with basis.
• Total premiums quoted at purchase. The premiums you actually paid, in the years you actually paid them, are what count. A planned premium that was reduced, skipped or paid from dividends changes the total.

Basis also changes over time. Every premium you pay raises it. Every tax-free withdrawal and every dividend taken in cash lowers it. On a modified endowment contract, a taxable loan or withdrawal raises it again, because you have already paid tax on that gain. That is why a worksheet beats a guess: you are tracking a running balance, not a single figure from the day you bought the policy.

Step 1: collect the records

Start by asking the insurer for the facts it already holds. Most companies can produce these on request, and some publish them in an online account.

1. A premium history. Every premium received, by date, for the life of the policy. If the premium was paid by an employer, a former spouse or a business, say so, because that affects who has basis (more on this below).
2. A dividend history, for participating whole life. The year-by-year dividends and what happened to each one: paid in cash, used to reduce premium, left on deposit, or used to buy paid-up additions riders explained.
3. A transaction history. Partial withdrawals, partial surrenders, loans, loan repayments, and any change in the death benefit.
4. The current statement. Cash value, surrender charge, loan balance and accrued loan interest, as of a specific date.
5. The policy's tax status. Ask in writing whether the policy is a modified endowment contracts and the 7-pay test. If the answer is yes, the order of taxation flips, and the worksheet changes.
6. Any rider charges. Charges for some riders reduce basis. For example, charges for a qualified long-term care rider can be treated as a reduction, and the insurer is the one that knows. Ask whether any rider charges are reported as reducing your investment in the contract.

If the insurer cannot give you a premium history, rebuild it from bank records, old annual statements or the premium notices. Keep a copy of whatever you assemble. Gaps are common in policies more than a couple of decades old, and an honest reconstruction with the insurer's confirmation is far better than a guess you cannot support later.

Step 2: the worksheet

Work from top to bottom. Each line has a plain-language note, and the right-hand column is yours to fill in.

Two clarifications make the lines work.

Line A counts what you paid, not what was billed. If dividends were applied to pay part of a premium, the portion the dividend covered was never your cash, so it should not sit in line A and again in line B. The cleanest approach is to use out-of-pocket premiums in line A and to enter in line B only dividends sent to you as cash. Dividends used for paid-up additions are generally treated as received and then reinvested, which leaves basis tracking your out-of-pocket premiums. Confirm the insurer's treatment, because the way a company records them varies.

Interest is a separate matter. Interest earned on dividends left on deposit is generally taxable when it is credited and reported to you each year. It does not reduce your policy basis. See life insurance dividend options: cash, paid-up additions and more for how the options differ.

Step 3: the loans, which basis ignores until the end

On an ordinary policy, a loan is generally not income while the policy stays in force, and it does not lower basis. That is the reason loans are popular, and also the reason they hide a danger. If the policy ends by surrender or lapse while a loan is outstanding, the loan is treated as an amount you received. The worksheet therefore needs a second block for the day you actually end the policy.

Notice what happens to the surrender charge. It reduces the cash you receive, so it reduces the amount treated as received and therefore the gain; the surrender charge schedule in your contract shows how large it is in the year you act. The loan works the other way: it is paid out of the proceeds, so it reduces the check but not the gain, which is why line M adds it back. If M is smaller than your basis, there is no gain, and the loss on a personal-use policy is generally not deductible.

A worked illustration: an ordinary whole life policy

The following is hypothetical, with round numbers chosen for the arithmetic. It is not a market price or a real policy.

Say Marcus, 61, has owned a participating whole life policy for 20 years. He pays $3,600 a year.

• Premiums paid: $3,600 × 20 = $72,000 (line A).
• From year 11 on, he took his dividend in cash, $800 a year for 10 years: $800 × 10 = $8,000 (line B).
• In year 18 he made a $5,000 partial withdrawal, which was inside basis and came out tax-free: $5,000 (line C).
• No other tax-free amounts, no basis-reducing rider charges, and the policy is not a modified endowment contract (lines D, E and G are zero).

Basis: $72,000 − $8,000 − $5,000 = $59,000 (lines F and H).

Now Marcus is thinking about surrendering, so he asks for a surrender quote. The quote shows a cash value of $110,000, no remaining surrender charge, and a loan balance of $20,000 including interest.

• Check received (L): $110,000 − $0 − $20,000 = $90,000.
• Amount treated as received (M): $90,000 + $20,000 = $110,000.
• Taxable gain (N): $110,000 − $59,000 = $51,000, taxed as ordinary income, not as a capital gain.

The lesson is the gap between the cash and the tax. Marcus holds a check for $90,000, but his gain is computed on $110,000. Had he guessed his basis was $72,000, the total premiums he paid, he would have estimated a gain of $38,000 and underestimated it by $13,000, which is exactly the $8,000 of cash dividends plus the $5,000 withdrawal he forgot to subtract.

The alternative Marcus might weigh is a smaller, partial withdrawal. Taking $40,000 out of an ordinary policy is generally tax-free because $40,000 is below his $59,000 basis, though his basis then falls to $19,000. A withdrawal can also reduce the death benefit and has special rules in the first 15 years of a policy, which the withdrawing cash value from a life insurance policy guide covers.

A second illustration: a modified endowment contract

The next case is also hypothetical, and it shows how the same worksheet changes when the policy failed the seven-pay test.

Say Priya, 52, put a single premium of $50,000 into a policy that became a modified endowment contract. After a few years the cash value is $62,000.

• Basis is $50,000. The gain inside the policy is $12,000.
• Priya borrows $10,000. On a modified endowment contract, loans are taxed gain-first, so the whole $10,000 is taxable income, and because she is under 59½ it can carry a 10% additional tax. That is $1,000 on top of the income tax, in principle.
• Because she has already been taxed on $10,000, line G adds $10,000 to her basis: adjusted basis is $50,000 + $10,000 = $60,000.

Later the gross cash value is $66,000 and she surrenders with the $10,000 loan still outstanding (ignoring loan interest to keep the arithmetic clear).

• Check received (L): $66,000 − $10,000 = $56,000.
• Amount treated as received (M): $56,000 + $10,000 = $66,000.
• Taxable gain (N): $66,000 − $60,000 = $6,000.

Across the life of the policy Priya received $10,000 plus $56,000, which is $66,000, from a $50,000 investment. The total gain is $16,000, and the two taxable events add up to it: $10,000 at the loan and $6,000 at the surrender. Tracking line G is what keeps the same dollars from being taxed twice. See modified endowment contracts and the 7-pay test for the test and the penalty.

Special situations that change the answer

The worksheet covers the common case. These situations deserve a question to the insurer or a tax professional before you rely on it.

• A policy you did not buy. If you received the policy as a gift, as part of a divorce, or from a business, your basis may carry over from the prior owner, or it may be set by the transfer. The rules differ by how the transfer happened, and ownership changes can have other tax consequences. The transferring ownership of a life insurance policy guide introduces them.
• A policy that came through a 1035 exchange. Basis generally carries over from the old contract into the new one, which is one of the reasons to keep the paperwork from the exchange. See 1035 exchanges: swapping policies without tax.
• Premiums paid by someone else. If an employer or former spouse paid premiums, whether those payments count as your basis depends on whether they were taxed to you or were otherwise part of your investment. This is a question for a tax professional.
• Policies with waived premiums. Premiums waived under a waiver-of-premium rider were not paid by you, so they generally do not add to basis.
• Policies sold to a third party. A sale to a settlement company uses basis too, and the rules there are covered in the companion post surrender or sell a policy, and how each exit is taxed in principle.
• A withdrawal in the first 15 years that reduces the death benefit. The tax code can treat part of it as coming out of gain first. Ask before you take it.

Check your work against the insurer

Once you have an answer, compare it with what the insurer will report.

1. Ask for a basis or "investment in the contract" figure. Many insurers can state it, and the tax form they eventually issue will show their figure.
2. Compare it with your worksheet line by line. If theirs is higher than yours, find the dividends or withdrawals they did not count. If theirs is lower, look for premiums they may not have recorded, such as a premium paid at another company before a merger.
3. Resolve differences in writing before the transaction. A surrender or sale is hard to undo, and a correction to a tax form after the fact is slower and harder.
4. Keep the final worksheet. Save it with the policy, the statements and the insurer's confirmation for as long as you hold the policy and several years after.

If you are comparing several choices, such as keeping, surrendering or selling, the keep, surrender or sell your policy? lays them side by side, and the surrendering a life insurance policy: what you get and what it costs guide shows how to request a surrender quote.

Mistakes the worksheet is built to prevent

• Using total premiums as basis. This ignores cash dividends and earlier withdrawals, and it overstates basis.
• Forgetting the loan on the day of surrender. The gain is measured on the amount you are treated as receiving, not on the check.
• Treating a modified endowment contract like an ordinary policy. The order of taxation flips, and a 10% additional tax can apply to the taxable part before age 59½.
• Counting the same dollar twice. A premium paid by a dividend should not also be treated as a dividend taken in cash.
• Trusting memory. Premium records spanning decades are rarely complete. Ask for the insurer's history before you decide.

Key takeaways

• Basis is generally the premiums you paid out of pocket, minus tax-free amounts already received such as cash dividends and earlier withdrawals, and it moves every year.
• On a surrender or lapse, the taxable gain is measured on the amount treated as received, including any loan wiped out, so the tax can exceed the check.
• On a modified endowment contract, taxable loans and withdrawals raise your basis because the gain was already taxed, so track that addition so it is not taxed twice.
• Ask the insurer for the premium, dividend and transaction history and its stated basis, and reconcile any difference in writing before you act.
• A tax professional should confirm the final figure for a large surrender, a sale, or a policy that has changed hands.