Life Insurance Cost Basis: A Smart Financial Planning

If you’ve ever sold an asset like stock or real estate, it’s likely that you’ve had to report your cost basis for that asset when you filed your taxes. There are many factors that contribute to determining your life insurance cost basis, including the investment vehicle, the calculation method and how you acquired your asset. According to the IRS, it’s up to you, the taxpayer, to accurately report your cost basis when you file your taxes, so it’s important to have a basic understanding of how it works in order to maximize your tax benefits.

What is the Cost Basis?

Cost basis, also referred to as tax basis, is generally the amount paid for an asset or investment. When referring to equity investments the cost basis is the original value of an asset for tax purposes, usually, the purchase price, adjusted for stock splits, dividends, and return of capital distributions.

This value is used to determine the capital gain, which is equal to the difference between the asset’s cost basis and the current market value. The cost basis for commodities is the difference between the purchase price and the futures price.

It is important to calculate and use the correct life insurance cost basis as it will have an impact on the amount of taxes you pay. This becomes especially important if you are invested in dividend-paying stocks and are re-investing your dividends rather than taking your earnings as income.

The re-invested dividends increase the cost basis of your investment and will ultimately lead to a lower tax bill when you take your capital gains.

Cost Basis in Life Insurance

Cost basis is the total amount that you paid into an asset, like a stock, your home, or even a permanent life insurance policy. It is usually calculated starting with the purchase price or, when it comes to permanent life insurance, the premiums you pay on your policy.  

Basis also generally includes fees or commissions required to invest. For example, if you are purchasing stocks, you would calculate the life insurance cost basis by adding up the share price and any commissions or fees you had to pay to facilitate the purchase. This gets more complicated if you’re reinvesting dividends on a stock you purchased rather than taking them out as a capital gain. The reinvested dividends add to the cost basis of your stock holdings over time.  

If you are purchasing a home, you can add things like attorney fees, owner title insurance, transfer taxes, real estate fees, and other closing costs to your cost basis. You might also be able to add the cost of certain home improvements to the cost basis of your property if they are permanent renovations that add value.   

Cost basis is also sometimes referred to as “tax basis” because it’s often used to calculate taxes you will owe. When you sell your investment or asset you will need to determine your cost basis and subtract your basis from the amount you receive on the sale. The difference between the amount you receive and your cost basis determines the amount you owe in taxes.  

How do you calculate your life insurance cost basis?  

An important part of calculating your cost basis is keeping good records. This can be easier for some assets and investments than others. For example, your investment brokerage account will typically keep track of the cost of your investments as well as the fees and other expenses related to your purchase or sale of investments. 

However, calculating cost basis can be more complicated if you’re doing so for a home that you have lived in for a while and renovated over the years. Keeping good records or adding up your cost basis every year would make it easier to keep track.  

The life insurance cost basis is relatively easy to calculate and often your insurer will calculate it for you. It’s typically the amount you paid in premiums for your policy. 

Why does the cost basis matter with life insurance ?

With permanent life insurance, in addition to the death benefit, the policy will accumulate a cash value that you can access throughout your lifetime.1 While there are several ways to access your cash value, including taking a loan against the policy, some people choose to surrender a portion or all of their policy. 

When surrendering a policy, you can generally take your cash value tax-free up to the cost basis. Anything above that amount is taxed as ordinary income. Because of this, some people who no longer need their full death benefit choose to surrender a portion of their policy — taking out the amount of cost basis tax-free. Then, the rest of the policy stays intact, providing a legacy for loved ones. 

Why cost basis matters on investments and assets 

Being able to calculate the cost basis of your investments and assets means that you will be better prepared to understand the tax implications of selling your investments – whether it’s a mutual fund you own or a family cottage you share with your siblings.  

Unexpected and unplanned-for-tax bills can have unpleasant financial consequences. Miscalculating the life insurance cost basis could result in paying more than you need to in taxes. Knowing how to properly calculate cost basis could minimize your tax burden.  

Need help calculating your cost basis?  

If you’re unsure how to calculate the cost basis of your investments or assets and want support, consider reaching out to a tax advisor.  A tax advisor can help you understand how to calculate your capital gains using the cost basis of your investments or life insurance cash value so that you can come up with a tax strategy that works best for you and your financial goals.  

Utilizing the cash value through policy loans, surrenders, or cash withdrawals will reduce the death benefit; and may necessitate greater outlay than anticipated and/or result in an unexpected taxable event. Assumes a non-Modified Endowment Contract (MEC).  

Consult with a tax professional for tax advice that is specific to your situation.

Why Is Life Insurance cost basis Important?

The cost basis primarily needs to be tracked for tax purposes. Without this requirement, likely, most investors would likely not bother keeping such detailed records.

Capital gains can be taxed at ordinary income rates in the case of short-term capital gains, so it pays to minimize them if at all possible. Holding securities for longer than one year qualifies the investment as a long-term investment, which carries a much lower tax rate than ordinary income rates and decreases based on income levels.

In addition to the IRS requirement to report capital gains, it’s wise to track how an investment has performed over time. Savvy investors know what they have paid for a security and how much in taxes they have to pay if they sell it.

Tracking gains and losses over time also serves as a scorecard for investors and lets them know if their trading strategies are generating profits or losses. A steady string of losses may indicate a need to reevaluate the investment strategy.

Ways to calculate life insurance cost basis

For equities such as stocks, mutual funds, and exchange-traded funds, there are three primary methods investors use to calculate cost basis:

– FIFO

The “first in, first out,” or FIFO, method for calculating cost basis works exactly how it sounds. This method usually applies if you bought shares of the same company at different times. When you sell shares, you would use the price of the first shares “in” as your basis.

For example, say you bought 10 shares of XYZ on Jan. 5, 2017, for $1,000 ($100 per share). On June 10 of the same year, XYZ was trading at $120 per share, and you decided to purchase 10 more shares for $1,200. If you decided to sell five shares today, using the FIFO method your cost basis would be $500, or the price you paid for the first shares of XYZ that you purchased.

Using the same example, let’s say you decided to sell 15 shares of XYZ. Using the FIFO method here, your cost basis for the first 10 shares would be the first shares that you purchased, or $1,000 (the first shares “in”). Your cost basis for the additional five shares would then be $120 per share, or $600. Adding everything together would give you a cost basis of $1,600 for all 15 shares that were sold.

– Average cost

The average cost method for determining life insurance cost basis is most commonly used for mutual funds. To calculate your basis, the average cost method takes the cost of all the shares you have purchased and divides it by the number of shares. Using the example above, if you purchased 10 shares of XYZ for $100 each and then 10 more shares for $120 each, your cost basis would be the total cost ($2,200) divided by the total number of shares (20 shares), or $110 per share.

– Specific shares

The specific shares method allows you to select which shares to sell. This method can be beneficial if you’re trying to limit the potential tax consequences of the sale. Using the example above, you could choose whether you wanted your cost basis to be $100 or $120 per share. This method allows for more flexibility, as you can choose which cost basis is more beneficial to you based on your tax situation.

The Bottom Line

The cost basis is the original value or purchase price of an asset or investment for tax purposes. It is used to calculate capital gains or losses, which is the difference between the selling and purchase prices of capital assets. Tracking life insurance cost basisis required for tax purposes. It is also key if investors want to determine their investments’ success.

FAQs

1- What Is Tax-Loss Harvesting?

Tax-loss harvesting involves selling investments at a loss to offset gains in other investments, reducing your taxable income. This strategy can help lower your overall tax bill and is particularly useful in years with significant capital gains.

2- How Does Tax-Loss Harvesting Work?

By selling underperforming investments, you can realize a loss that offsets capital gains from other investments. If losses exceed gains, they can reduce other taxable income by up to $3,000 per year, with any excess carried forward to future years.

References:

• https://www.northwesternmutual.com/life-and-money/what-is-cost-basis-and-how-do-you-calculate-it/
• https://www.investopedia.com/articles/investing/060313/what-determines-your-cost-basis.asp#toc-what-is-first-in-first-out-fifo-for-taxe