The adjusted cost basis (ACB) of a life insurance policy is the measure the ITA uses to determine the taxable portion of any disposition proceeds. It functions similarly to cost base in other investments: proceeds in excess of ACB are the taxable gain.
Components of ACB (simplified):
- Start with all premiums ever paid into the policy.
- Subtract the cumulative net cost of pure insurance (NCPI): a notional cost representing the pure mortality protection element of the policy, which reduces ACB over time because that portion of premiums pays for insurance and does not contribute to investment accumulation.
- Add or subtract other adjustments for policy loans, dividends, and changes in coverage.
Key relationship: ACB generally declines over time as NCPI accumulates. A policy held for many years may have a very low ACB even if large premiums were paid, because decades of NCPI reductions have eroded it.
Why ACB matters: when the policy is surrendered, a partial withdrawal is made, or a policy loan is taken above the ACB, the excess is a taxable disposition.
Common mistake: assuming that all policy withdrawals are tax-free because "life insurance is not taxable." The death benefit paid on death from an exempt policy is tax-free; a surrender or withdrawal is a disposition, and proceeds above ACB are taxable income.
Recall: What reduces the ACB of a life insurance policy over time? Why might a policyholder who paid large premiums for 30 years still face a taxable gain on surrender?