California Life and Health Insurance Practice Exam

The cost recovery rule specifies that when a life insurance policy is surrendered, the cost basis is exempt from taxation. This means that the amount of money you had originally invested in the policy (the premiums paid) can be recovered without incurring any income tax consequences. This rule is designed to ensure that policyholders are not taxed on the money they have paid into the policy, as they have already been taxed on those funds.

When a policy is surrendered, any gain (the amount received upon surrender minus the cost basis) may be subject to income tax, but the initial premiums paid are not. This helps prevent double taxation on the amounts that the policyholder has already contributed.

Other potential interpretations, such as the policy being fully taxable or only the cash value being taxable, mischaracterize the tax treatment under the cost recovery rule. Additionally, the idea that premiums paid could be refunded does not align with how surrender of a policy typically works, as it generally does not involve returning premiums, but rather representing the remaining cash value at that point in time.