Common misconceptions about life insurance tax benefits

There are a few conditions involved before you enjoy these tax benefits on insurance payment and receipts. During sales pitches, these conditions and their effect may be conveniently ignored. However, as an informed buyer, you must be aware. In this post, let’s look at such conditions imposed through income tax laws.

Any amount paid towards life insurance premium for yourself, your spouse and children qualify for deduction under Section 80C. However, the premium paid by you for parents/siblings/in-laws is not eligible.

The tax benefit is capped at Rs 1.5 lakh under Section 80C. So, even if you pay Rs 4 lakh annually, the tax benefit is capped at Rs 1.5 lakh per annum. And that’s for the entire Section 80C basket. Additionally, the entire life insurance premium paid may not be eligible for tax deduction. The quantum of insurance premium eligible for tax deduction is restricted in relation to the Sum Assured (Minimum Death Benefit). Here are the rules.

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.

If the policy is issued on or after April 1, 2012, annual premium up to a maximum of 10% of Sum Assured is tax deductible. Additional relaxation of 5% (i.e. up to 15% of Sum Assured) is available to a person suffering from a disability or severe 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 the death of the policyholder. In simple words, Sum Assured is the minimum death benefit.

Let’s consider an example. If you purchase an insurance policy with a sum assured of Rs 4,00,000 and an annual premium of Rs 50,000, only Rs 40,000 (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. Please note tax deduction is subject to an overall ceiling of Rs 1,50,000 under Section 80C.

This can happen when you club investments and insurance.

With term insurance plans, you will likely be safe. This is because the Sum Assured is a much higher multiple of the annual premium. For instance, you may be able to purchase Rs 1 crore cover for about Rs 10,000-12,000 per annum. The Sum Assured is almost 1000 times the annual premium. Therefore, the entire premium is likely eligible for tax deduction.

The problem comes with ULIPs and traditional life insurance plans. More so when you are old (at the time of entry) or with single premium plans.

With Single Premium life insurance plans, the minimum death benefit (Sum Assured) will most likely be lower multiple of the annual premium, say about 1.1 to 1.5 times. As discussed in the previous section, you will get tax benefit for only 10% of the Sum Assured. If you pay Rs 1 lakh as one-time premium for Rs 1.25 lac cover, your tax benefit under Section 80C will be capped at Rs 12,500. If you are planning to purchase a single premium plan, do keep this aspect in mind.

If you are young, IRDA rules will ensure that you are comfortably clear. For instance, in case of ULIPs, if you are younger than 45, the Sum Assured must be at least 10 times the annual premium for regular premium plans. So, the rules will save you. However, if you are older, the rules may not provide you such protection. If you are over 45, there is no such protection.

Here is the tabulation of minimum Sum Assured as per IRDA Linked Insurance Products Regulations, 2013.

Any proceeds from an insurance policy resulting from the death of the policyholder are tax-free.However, the same cannot be said for maturity proceeds.

The proceeds from the insurance policies (other than in the event of death) that do not meet the aforementioned criteria (Minimum Death Benefit >=10 times annual premium) are taxable at the time of maturity. This typically comes as a shock for many investors, especially buyers of single premium plans.

You must keep this aspect in mind.

For any new policy purchase where annual premium exceeds 10% of the sum assured (minimum death benefit):

You will not get tax benefit for the entire premium paid.

The insurance payout (other than in the event of death) will be taxable.

If you think you will just not report this income and avoid paying any taxes, you are mistaken. There is TDS involved too. If your insurance proceeds are taxable, the insurance company will deduct TDS at 5% on the taxable portion of your insurance payout. This rule has been introduced in Union Budget 2019 (final).

By the way, TDS was involved before Budget 2019 too. Earlier, TDS was deducted at 2% of the payout, then modified to 1% of the payout and now this has been changed to 5% of the taxable portion. So, TDS was on the entire payout earlier. Now, the TDS is on the taxable portion (insurance payout – premiums paid).

TDS makes it very easy for tax officials to track your insurance payout. If you do not report such income in your ITR, then you can be in serious trouble. Do note TDS does not complete your tax liability. If you fall in the higher tax bracket, you will have to pay additional tax at the time of filing ITR.

A financial product’s tax structure is one of the critical elements that are considered before the purchase of a financial product. However, you must never purchase a financial product just to save taxes. For instance, loading up on 5-year fixed deposits year after year just to save taxes is not going to help you meet your long term goals. The product should fit into your overall financial planning. If such a product helps you save taxes, that is an additional positive.

It is better to keep your insurance and investment needs separate. I have written about this many times. Post 1 Post 2 Post 3 If you buy a pure term insurance plan, these restrictions are unlikely to be a problem as the Sum Assured is a very high multiple of premium paid. A Sum Assured of Rs 1 crore will have an annual premium in the range of Rs 8,000-12,000 for a 30-year-old. It is when you mix your investment and insurance needs that these restrictions can come into play.

If you have decided to purchase an insurance plan, do keep this taxation aspect in mind. Don’t go just by the words of the insurance salesperson. If you purchase an insurance policy where annualized premium exceeds 10% of the Sum Assured, only a part of your insurance premium will be tax deductible. Not only that, the proceeds from such an insurance policy will be taxable at the time of maturity.

What would you do?