When you invest in bank fixed deposits (FDs), you know very well that the interest income is subject to tax as per your tax slab. When you buy tax-free bonds, the rules are also easy to know. Your interest is tax free. But when you invest in any insurance policy for getting a tax deduction at entry with Section 80C, you are also supposed to think that your maturity proceeds will be tax free under Section 10(10D). Though this may be true in many cases, but not in all cases. The Finance Act, 2014, had introduced many tax provisions on the maturity, surrender or withdrawal amount of life insurance policies that to be taxed partially and even insurance companies are confused. That’s why, life insurance companies now, advertise ‘Income Tax benefits under Section 80C and 10(10D)’, these have a fine print ‘as per prevailing tax laws’ or ‘consult your tax advisor for details’.  There are very less people, even your insurance agent known about tax implications on life insurance proceeds. Now onwards, many insurance products do not qualify for tax-free returns and only partial tax deduction at entry. Moreover, if you do not pay more than one premium for a regular premium policy, you will have to even give up the Section 80C deduction that you had already availed. In this cobra post, we have examined the impact of tax on your life insurance proceeds which have already been going under low returns, may end up with abysmal returns, if you have to pay tax on your life insurance policy.

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TDS on Life Insurance Proceeds

Insurance products tend to give you a straight forward deduction of up to Rs1.5 lakh from your taxable income under Section 80C. But it is half backed tax saving provision as it had already made it mandatory for policy issuance, effective April 2012, that the sum assured should be at least 10 times the annualised premiums for those life insurance policies to enjoy the tax benefits on contributions under Section 80C and on maturity under Section 10 (10D). The earlier limit was five times for policy issuance (from April 2003 to March 2012). Numerous life insurance products are available in the market that do not qualify for full tax savings on entry and will have no tax exemption on maturity; but rarely do insurers, and their intermediaries, disclose this to customers. The new section 194DA of the Income Tax Act, 1961, that took effect on 1 October 2014, envisages TDS on life insurance policy payouts which are not exempt under Section 10(10D) and total amount paid to a policyholder towards non-exempt policies exceeds Rs1 lakh in a financial year, would attract a 2% TDS (tax deduction at source) on the maturity, surrender or partial withdrawal amount of life insurance policy.

If you are buying a life insurance product, which does not qualify tax-free returns, this may be an absolute disaster for your investment, delivers poor returns even after investing for a long time, if you still have to pay tax on it. For instance, if your total premiums were paid Rs700,000 in entire tenure and the policy payout is Rs10,00,000 at maturity, gains are Rs3,00,000. If you are in the 30% tax bracket, you may have to pay tax of Rs90,000. The TDS will be @2% of Rs10,00,000 (that is, Rs20,000). You will have to pay the remaining Rs70,000 (Rs90,000 minus Rs20,000) while filing your tax returns, or pay advance tax, depending on your income level.

Taxes on Single Premium Products

Some investors are putting lakhs in single-premium products like LIC Bima Bachat under the impression that they can earn tax-free returns. But they would be getting a bigger shock to know that product does not qualify for tax-free returns under Section 10(10D). IRDA guidelines allow single-premium product to offer minimum death benefit of 1.25 times of single premium and 1.10 times of single premium, for those above 45 years of age. Clearly, if you are buying a single-premium product and you are above 45 years, you need to closely check whether the product qualifies for tax-free returns as, in most cases, the insurance cover will be too low to qualify for Section 10 (10D) tax-free corpus. If you are not healthy, the situation may be worse as your insurance company can load your premium and your sum assured may not be 10 times the premium and, therefore, is to be taxable. The higher the age, the higher will be the loading in case of health issues due to higher risk for the insurer. It does throw your calculations of tax-free returns into dark. Moreover, those living in rural and small towns will be severely affected by the new provisions, in case they do not have PAN cards. They will end up with 20% TDS instead of 2%.

Taxing due to Not to Pay Minimum Premiums

Suppose you had bought a regular premium policy and stopped paying after the first premium, since there will be no TDS; but you will still be taxed due to discontinuation of premium by reversing the 80C tax benefit which you had availed. You should pay minimum of two premiums for life insurance policy to avoid this reversal. Taxation is also applicable for single-premium policy, if you terminate it within two years after the commencement date. The same holds true for ULIP (unit-linked insurance policy) plans which they need to pay minimum five ULIP premiums, to avoid this tax anomaly. People are more interested in getting Section 80C tax deduction by buying life insurance when there are several competing products to claim the benefit. They do not focus on ensuring that the maturity amount of their life insurance product is tax exempt under Section 10(10D) or not.  The worst part is that insurers and agents are often lax about explaining the tax implications while selling the product.

Pension gets Tax Tension

Do you know that pension plans from life insurance are the worst financial products with respect to return as well as taxation point of view? These are alike chewing gum, which one could neither swallow, nor throw out, one has to just chewy. If you surrender a pension product anytime before maturity, you will have to give back the tax deduction you had claimed under Section 80CCC. The surrender value has also to be added to your income and taxed as per your slab in the year of surrender. While tax benefits are reversed on surrender, annuity is taxed whether TDS is cut or not.  If you let the pension product mature, one third of the corpus can be taken out as tax free; the remaining has to be invested in an annuity product sold by the insurance company. An annuity policy will give you an average of 7% per annum returns for lifetime and, on the death of the policyholder, the purchase price is returned to the legal heir or nominee. There is an annuity option to get higher returns without return of purchase price to a nominee. Unfortunately, annuity returns are also taxable. If you do not want to invest in annuity, two-thirds of the pension corpus will be taxable. Generally, People correlate retirement planning with pension products and are easy targets. Also Read : Is your Pension Plan the hanging sword of Taxation

Conclusion

Everyone should know what happens to their policy. Ironically, people get intrigued about flawed pension products to their investments and financial problems and tend to take comfort from a with complex annuity plan, low yield guaranteed benefits, bullet points and calculations. They tend to get frustrated about investing in simple and plain-vanilla financial products. They do not recognize the real fact of inflation, taxation and returns on their investment, but they have to do just invest. Clearly, if you buy a simple insurance term plan and balance to invest in mutual funds, you do not need to worry about different interpretations of taxing products. Always remember, complex insurance products are so made as not to understand easy for any layman investors. For a buyer not aware of this, a nasty taxation shock may be waiting when the policy matures.

 

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Suresh Kumar Narula

SEBI Investment Advisor, Founder & Principal Financial Planner at Prudent Financial Planners
Suresh K Narula is founder and Principal Financial Planner at Prudent Financial Planners. He has earned the professional CERITIFIED FINANCIAL PLANNER and got registered with SEBI as Investment Advisor. He writes on personal and financial planning articles and got published in Dainik Bhaskar, Business Bhaskar and The Financial Planner's Guild, India. He is also a member of Financial Planner's Guild India ( An association of practicing SEBI registered Investment advisers) to create awareness about Financial Planning in general public, promote professional excellence and ensure high quality practice standards. Suresh received his an M.com from Himachal Pardesh University and an MFC from Punjab University, Chandigarh. He can be reached at info@prudentfp.in
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