Most people don’t buy right insurance products; they just given in to best sales presentation

Most retail investors use insurance products as tax saving instruments. Under Section 80C of the Income Tax Act, life insurance premium up to a maximum of Rs 1.5 lakh per financial year qualifies for tax deduction. Most of us leave tax planning till the very end of financial year. When the financial year end approaches, most of us give in to the best sales presentation from a financial intermediary without understanding the product features completely.

Financial planners often advocate that retail customers shall not mix their insurance and investment needs. Even then, in the rush to meet 80C tax deduction limit targets, most of us end up buying insurance products such as unit-linked insurance plans (ULIP) and endowment plans that offer the dual benefit of insurance and investment.

Whether insurance products make for good investment products is a different question altogether. In our opinion, you must keep your insurance and investment needs separate. However, this is not what we intend to discuss in this article. A lot of people buy such insurance products just to save taxes. We want to highlight that many such insurance products may not even provide you the expected tax benefits.

Which life insurance premium is tax deductible?

Any amount paid towards life insurance premium for yourself, your spouse and children qualify for deduction under Section 80C. However, premium paid by you for parents/siblings/in-laws is not eligible. Please note tax deduction is subject to an overall ceiling of Rs 1.5 lacs under Section 80C.

How much life insurance premium is tax deductible?

A common perception is that the entire life insurance premium qualifies for tax deduction. However, that is not the case. Not all life insurance premium paid is tax deductible. If the policy is issued on or before March 31, 2012, annual premium up to a maximum of 20% of the Sum Assured is tax deductible. In case the policy is issued on or after April 1, 2012, annual premium up to a maximum of 10% of Sum Assured is tax deductible. An additional relaxation of 5% (i.e. up to 15% of Sum Assured) is available to person suffering from disability or sever disability (as specified under Section 80 U) or to those suffering from a disease or ailment as specified under Section 80DDB.  For a life insurance policy, Sum Assured is the minimum amount assured to the nominee (of the policyholder) in the event of death of the policy holder.

Let’s consider an example. If you purchase an insurance policy with a sum assured of Rs 8 lacs and an annual premium of Rs 1 lacs, only Rs 80,000 (10% of Sum Assured) is tax deductible. You won’t get any tax benefits for the balance premium. Any premium in excess of the aforesaid limit (10% of Sum Assured for the new policies) shall not qualify for tax deduction under section 80C of the Income Tax Act.

Taxation of insurance proceeds

Getting tax deductions on insurance premium payments is one part. Other common perception is that the maturity proceeds from life insurance products are exempt from tax too. This is also not true.

Any proceeds from the insurance policy resulting from the death of the policyholder are tax free. Please note that the proceeds from the insurance policies (other than in case of death) that do not meet the aforementioned criteria (percentage of sum assured) are taxable at the time of maturity. Hence, for any new policy purchase, where annual premium for any year during term of the policy exceeds 10% of the sum assured, the insurance proceeds (other than in case of death) will be taxable. The insurance proceeds shall be taxed at policy holder’s marginal income tax rate (as per income tax slab).

Which insurance products are the worst hit?

Pure life insurance plans (term insurance plans) are unlikely to be hit by these conditions. Typically, the sum assured in term plans is a very high multiple of annual premium. For instance, For a 30 year old non-smoker male, sum assured of Rs 1 crore will cost an annual premium of Rs 6,000-12,000. There are no maturity proceeds in a term insurance plan. Death benefits are, in any case, exempt from tax.

The problem is there for insurance plans which provide investment benefits too i.e. insurance products such as endowment plans and ULIPs where sum assured is a much lower multiple of annual premium.

Under IRDA guidelines, for a life insurance product (for a person aged less than 45 years) with a policy term of 10 years or more, sum assured shall be at least 10 times annual premium. So, in such cases, you will receive tax benefits for sure. However, if the applicant’s age is 45 years or more or if the policy term is less than 10 years, IRDA has relaxed this minimum sum assured limitation. It is in these cases that you might lose out on tax benefits. Some plans give you the option of choosing your sum assured. If you are looking for tax benefits, choose the sum assured accordingly.

Single premium insurance policies are the worst hit. These are marketed as investment products and thus sum assured is kept low to enhance returns (lower sum assured means lower mortality charges and thus greater part of the premium gets invested). For single premium plans, sum assured is typically 1.25-1.5 times the premium. Hence, investment in such plans will not qualify for tax deduction.

Early surrender/termination of life insurance products

As per Section 80C of the Income tax Act, if you terminate your participation in a ULIP (by not paying premium or giving notice to the insurance company) before paying premium for five years, the aggregate amount of tax deductions allowed in the previous years for payment of life insurance premium shall be disallowed. The income for such previous years shall be adjusted accordingly and the policy holder will have to pay tax accordingly. For insurance products other than ULIPs, the premium has to be paid for atleast 2 years to avoid reversal of tax benefits taken in the previous years. For single premium policies, the insurance contract should not be cancelled within two years of commencement of insurance to avoid reversal of tax benefits.

Hence, you must exercise extra caution. If you purchase a wrong insurance product, you can either terminate the policy and forgo the tax benefits claimed in the previous years or continue with the wrong product for the minimum number of years. The insurance products are typically front loaded i.e. charges are higher in the earlier years. Therefore, if you surrender before the minimum prescribed period, not only do you forgo the tax benefits but also take a hit on your returns due to higher charges in the initial years.

TDS on insurance proceeds

Most retail customers are not aware of these conditions. Thus, they are likely to fall short of tax compliance.  Till now, there was no easy way for even the taxman to find out about your non-compliance. However, in the budget 2014-2015, the government moved to plug in this gap by introducing a provision for tax deduction at source (TDS) of 2% if the insurance proceeds are not tax-exempt. Now, the onus is on the insurance company to deduct TDS of 2% if the insurance proceeds are not tax exempt. This will leave a trail for the income tax department to follow to your door steps and send a tax demand. No TDS shall be deducted if the maturity proceeds are less than Rs 1 lac.

Things to remember

A financial product’s tax structure is one of the critical elements that are considered before purchase of a financial product. However, you must never purchase a financial product just to save taxes.  

We advise to keep your insurance and investment needs separate. As discussed above, if you buy a pure term insurance plan, the aforementioned tax restrictions will never be a problem as the sum assured is a very high multiple of premium paid. It is when you mix your investment and insurance needs that these restrictions can come into play.

You need to understand that purchase of a life insurance product involves a long term commitment to pay annual premium. If you realize that you have purchased a wrong product, even termination of such insurance plans shall have unintended tax consequences as discussed above.