Adjusted Cost Basis (ACB)

In the context of Life Insurance and Living Benefits in Canada, the "Adjusted Cost Basis" (ACB) refers to a calculation used to determine the taxable portion of the cash surrender value of a life insurance policy when it is partially or fully surrendered or when accessing the policy's cash value in some other taxable manner. The ACB is a crucial figure for tax purposes, as it helps to establish the amount of money from the policy that can be received tax-free versus the amount that may be subject to taxation.

The ACB is generally calculated by taking into account the premiums paid into the policy, less any dividends received or previous withdrawals made from the policy's cash value. The purpose of calculating the ACB is to reflect the investment component of the life insurance policy that has already been taxed, ensuring that policyholders are not taxed again on these amounts.

Key aspects of the ACB in life insurance include:

1. Tax Implications: When a policyholder withdraws from the cash value or surrenders the policy, the amount received over the ACB is considered taxable income. The ACB calculation ensures that policyholders are only taxed on the investment gains within the policy, not on the portion of the premiums that essentially represent a return of their after-tax contributions.
2. Decreasing Over Time: Typically, the ACB of a life insurance policy decreases over time according to a schedule set out by the Canadian Income Tax Act. This is because the insurance element of the policy (the risk of death) becomes a larger component of the premiums paid as the insured individual ages.
3. Impact of Policy Changes: Certain changes to a life insurance policy, such as increasing the death benefit, can affect the ACB. Policyholders considering changes or withdrawals should understand how these actions might impact the ACB and the potential tax implications.
4. Calculation Complexity: The calculation of the ACB can be complex, especially for policies with investment components or those that have undergone changes over time. It's often advisable for policyholders to consult with a tax professional or financial advisor to accurately determine the ACB and understand its tax implications.
5. Policy Loans: Taking a loan against the cash value of a life insurance policy does not directly impact the ACB, but interest on the loan may affect the policy's cash value and, subsequently, the taxable amount if the policy is surrendered.

Understanding the Adjusted Cost Basis of a life insurance policy is important for Canadian policyholders, especially when considering accessing the policy's cash value or making significant changes to the policy. Accurate knowledge of the ACB helps in making informed decisions that align with one's financial planning and tax strategy.