How are life insurance policies taxed?

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In very simple terms, life insurance is a contract you enter into with an insurance company. You, the policyholder, pay periodic premiums to the insurance company in return for a gross amount payable on the death of the insured (death benefit) and/or at the end of the term of insurance ( maturity service).

Tax advantages on the life insurance contract

Life insurance policies provide not only a maturity/death benefit but also tax deductions under Section 80C and Section 10(10D) of the Income Tax Act. income from 1961.

Let’s understand the two clauses that affect taxes related to life insurance –

Article 80c

Any resident or non-resident natural person may claim a deduction for the life insurance premium paid under Article 80 C up to 1.50 lakh every year. This deduction is available with other qualifying items such as PPF, NSC, ELSS, Fixed Deposits, Home Loan Repayment, Tuition Paid, Provident Fund Contribution, etc.

You can only claim an 80 C waiver for life insurance premiums up to 10% of the sum insured. For any premium paid above 10%, the deduction is not available. However, for some people classified as disabled or suffering from serious illness, up to 15% of the sum insured is waived, capped at INR 1.5 lakh per year.

Section 10 (10D)

Section 10(10D) of the Income Tax Act determines whether the proceeds at maturity of your life insurance policy will be exempt from tax or not. Section 10(10D) applies to any amount paid under the insurance scheme; be it a death benefit, plan maturation or other bonuses.

One important thing to remember is that death benefits are always tax free. Maturity benefits (paid in case of survival for a certain period of time) are sometimes taxed, based on the premium paid.

For life insurance plans purchased after April 1, 2012, under Section 10 (10D), if the annual premium paid is greater than 10% of the policy’s face amount, the maturity proceeds (benefits survival) would be taxed, according to your income tax plate. If not, the proceeds are tax exempt.

For life insurance policies issued between April 1, 2003 and March 31, 2012, the premium must be less than 20% of the sum insured to avoid taxation.

For certain people, who meet the following criteria:

1. Disabled or severely disabled persons as specified in Section 80U of the Income Tax Act 1961.

2. Persons suffering from illnesses as specified in Section 80DDB of the Income Tax Act 1961.

3. Maturity benefits are not taxed if premiums do not exceed 15% of face amount for plans purchased before April 1, 2013.

Eligibility Criteria for Section 10(10D) of the Income Tax Act

1. Tax deductions under Section 10(10D) are available for life insurance claim payments such as death benefits and maturity benefits, including accrued premiums.

2. Tax deductions under Article 10(10D) apply to all types of life insurance claim reimbursements.

3. There is no upper limit applicable to the tax benefits available under Section 10(10D) of the Income Tax Act.

4. Deductions are applicable to foreign and Indian life insurance companies.

ULIP taxation

Section 10(10D) benefits also apply to all gains from Unit Linked Insurance (ULIP) schemes and single premium life insurance policies (if the above conditions are met). ).

As a reminder, ULIPs are policies where you pay the premium for a certain number of years (usually around 5), which the insurer invests for you, while offering life insurance coverage (usually for an insured sum of 10 lakhs). Once the premium payment period is over, there is a holding period (example: 5 more years) and then you receive a maturity benefit. So an example of ULIP is where you pay 1 lakh per year for 5 years, and 5 years later the insurer reimburses you a lump sum of 10 lakhs*. If you die within this time frame, your beneficiaries receive an additional death benefit of INR 10 lakhs.

*This sum is for illustrative purposes only, ULIPs are linked to equity and debt markets and returns vary.

Traditionally, ULIP premiums were exempt under Section 80C and maturity benefits were also exempt under Section 10(10D).

However, for ULIPs, a new rule was introduced in 2021, which applies to ULIPs purchased on or after February 1, 2021. The rule is simple:

If the annual premium paid to ULIP is more than INR 2.5 lakhs, there is no tax exemption on the returns. Any taxable return is treated as a capital gain (not income tax).

Let’s look at some examples –

Example 1

As an example, let’s say you buy an ULIP on April 2, 2021. Every quarter, you pay a premium of INR 65,000. You pay for 5 years, and for 5 more years after that the money is invested by the insurer, who then pays you benefit at maturity of INR 21 lakhs on April 2, 2031. The policy had a life sum insured of INR 15 lakhs (if you die within these 10 years, your family will receive 15 lakhs).

You can claim an income tax exemption of 1.5 lakh under the limit of 80C, for each year you pay the premium. On the maturity amount of 21 lakhs, you will not be able to claim any tax deduction, as your annual premium is 65000×4 = 2.6 lakhs. Since your annual premium paid is more than 2.5 lakhs, no exemption is given on your returns and they will be taxed as Long Term Capital Gains (LTCG).

In the unfortunate event of your death during these 10 years of policy activity, your family would receive the insured 15 lakh death benefit tax-free. However, at the end of the 10 years, when the maturity benefit will materialize, the 21 lakhs will still be taxed as long-term capital gains, as the annual premium was over 2.5 lakhs.

Example 2

Now let’s take another example where you took an ULIP, on April 2, 2021. You pay 1 lakh per year for 5 years, and for another 5 years the money remains invested, until the insurer pays a Maturity benefit of INR 12 lakh on 2nd April 2031. The policy has life insurance cover of INR 5 lakh in the event of death within 10 years that the policy is active.

Even if you pay a premium of 1 lakh, you can only claim INR 50,000 as income tax exemption under Section 80. This is because the life sum insured (i.e. i.e. sum insured) is INR 5 lakh, and you can only claim 10% of it as income tax exemption during the 5 years you pay the premium.

Maturity benefits, however, are fully tax-free, as the annual premium you pay is less than 2.5 lakhs.

In general, separating insurance and investments is always preferable to the alternative and gives better returns. A term life insurance policy coupled with a healthy investment portfolio generally yields better returns than any individual life insurance policy, while providing important life insurance coverage for your family. If you like the simplicity and comfort of having money managed by advisors, then investment-linked policies might be right for you, provided you meet the tax exemption limits.

Author: Avinash Ramachandran, COO and Sunil Padasala, Director of Innovation and Strategy, Assurekit

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