How does the cost recovery rule apply when a life insurance policy is surrendered?

When a life insurance policy is surrendered, the cost recovery rule dictates that the policyholder can recover the basis of their investment in the policy before any taxable gains are realized. This means that the amount paid in premiums (the cost basis) can be withdrawn tax-free.

In the context of surrendering a life insurance policy, the cost basis refers to the total premiums paid into the policy rather than the cash value at the time of surrender. The specifics of this rule allow policyholders to remove the portion of their initial investment from taxation, provided they have not exceeded the cumulative premiums paid in relation to any distributions they receive.

This means when a policyholder surrenders their life insurance policy, they do not have to pay taxes on their initial investment (the cost basis), as they are simply recovering what they have contributed. Any amount received above the total of the premiums paid would then be taxable as income, but the initial investment is tax-exempt under the recovery rule. Thus, under this reasoning, the correct understanding of the cost basis in the context of policy surrender aligns with the answer provided.