ULIP taxation: Tax benefits on investment in ULIPs under Sec 80C and Section 10(10D), Tax-free switches

ULIPs are a blend of insurance and investment in the stock market. It is crucial to understand the taxability angle before investing in these instruments.

Unit Linked Insurance Plans (ULIPs) have gained popularity for their dual benefit of insurance and investment with attractive returns. ULIPs have a flavour of both equity and debt products and are built upon the insurance theme. They seemingly provide the best of both worlds. Despite being equity-oriented instruments, they enjoyed tax benefits (as with other conventional insurance products) under Section 10 (10D) of the IT Act until the changes in the budget of 2021. 

Before we discuss the taxation on ULIPs, let us understand how they work.

What is a ULIP, and how does it work?

ULIP is a combined long-term investment plan. It can be used to achieve long-term financial goals alongside a life cover that is intended to protect your near and dear ones financially in the event of your unfortunate demise. A certain predetermined annual premium paid towards this plan is routed towards the life cover, and the rest is invested in funds as per the investor's preference and the risk appetite. Depending on the risk profile/appetite of the investor (the insured), debt, equity, or a combination of the two in acceptable proportion can be chosen. 

The benefits derived from ULIP Insurance can be categorised as follows:

Also Read: ULIP Vs Mutual Fund: Where To Invest?

• Life cover: As with any other insurance product, these plans offer coverage of up to 40X the annual premium. In the event of the insured’s demise, the life cover is paid out to the family/beneficiary.
• Investment benefit: The funds in excess of the stipulated life risk cover can be invested in equity, debt, or balanced (combination of equity and debt) in a proportion that suits the insured. These funds have the potential to create wealth in the long run. The funds are allowed to be switched, as in the case of mutual funds.
• Withdrawal: Most ULIPs allow partial withdrawals. Such withdrawals do not attract any penalty/charges unless otherwise specified by the insurance company as part of the policy. This facility comes in handy during emergencies, intermediate goals, etc.

Tax benefits on investment in ULIPs

While taxability is often synonymous with a significant monetary outgo, annual premiums paid towards ULIPs enjoy certain tax benefits. ULIPs provide EEE (Exempt, Exempt, Exempt) tax benefit at the time of investment gains as well as maturity.

• Taxes on premium payment: The annual premium paid towards ULIPs qualify for tax benefit under Section 80C, which has an overall limit of Rs 1.5 lakh. Other investments qualify for tax benefit under this section, such as EPF, ELSS, fixed deposits with a minimum 5-year lock-in, etc. However, this deduction is capped at 10% of the sum assured, so any premium paid beyond this limit does not qualify for deduction under section 80C. E.g. If the sum assured is Rs 1 lakh, a premium up to Rs 10,000 per annum would qualify for an 80C benefit. Further, reversal of tax benefits (received under Section 80C) is applicable if the premium is stopped before the expiry of five years or on termination of policy within the 5-year horizon.
• Taxes on the maturity of the ULIP: The amount that you receive upon maturity of the ULIP is called the ‘maturity amount’. Prior to Budget 2021, this amount was allowed for exemption under Section 10(10D). However, from 1 February 2021, no exemption is allowed under Section 10(10D) in the event of premium payment exceeding Rs 2.5 lakh (not only for the present year but for any previous year during the existence of the policy). The maturity benefit remains tax–free under Section 10(10D) if the premium paid is less than Rs 2.5 lakh during the entire tenure of the policy. This rule was introduced in the Union Budget in FY 2021-22 to level the playing field for mutual funds and unit-linked insurance, both of which offer a market-oriented flavour (equity as well as debt). The new taxation rule has to be considered while investing in ULIPs.

Also Read: 5 Women-Specific Financial Products You Must Take Advantage Of Today

• Tax-free switches: The biggest tax advantage of ULIPs is the tax-free switches between debt and equity without any short-term or long-term capital gains taxation, which is not available in any other investment product in the industry. This can help you rebalance your asset allocation without having to worry about income tax implications on the same!
• Proposed taxability of ULIP payouts under capital gains in the year of such payout: There is a proposal to introduce a new sub-section under Section 45, which is likely to bring any funds paid to the insured at any time during any of the previous years that do not qualify for exemption under Section 10(10D). The profits arising from such payout from ULIPs are proposed to be charged under capital gains in the year of such payout. The taxability is similar to that of equity-oriented products. It is applicable on all ULIPs with high annual premiums. There is a proposal to also bring switches done within equity and debt fund in ULIPs under the tax regime and treat them at par with switches in mutual funds that are treated for capital gains tax for any switchouts. 
• Taxability on the death benefit: Death benefit is payable to the beneficiary on the demise of the insured. This amount is tax-free in the hands of the recipient (the beneficiary/nominee). There are two types of ULIPs from the perspective of the death benefit for the policyholder, as listed below:

1. Type 1: Under this ULIP plan, the higher of the sum assured or the fund value is paid to the nominee in the event of the death of the policyholder. The money paid to the nominee under such a plan remains tax-free.
2. Type 2: This pays the sum assured in addition to the fund value to the beneficiary in the event of the death of the insured. The amount paid as part of the death benefit is always exempted from tax and remains tax-free in the beneficiary’s hands. 

• Securities Transaction Tax (STT) on ULIPs: STT will be levied on any amount received by the insured on maturity or any partial withdrawals from the plan. It is applicable on plans issued on or after February 2021. STT is applicable on ULIP for all those plans with higher premiums and on investment in equity-oriented funds only; it is not proposed on debt-based and money market or balanced funds. STT is levied at 0.001% on transaction value. The payment is made by the seller of the units. The insurer may make the payment at the time of the transaction and then collect or recover the STT from the insured at the time of payout. However, STT will not be levied on switching between schemes within the ULIP plan, partial withdrawal, or on the maturity amount. It is not applicable on death benefit payout. 

Note: For all ULIPs that were issued before February 2021, the erstwhile tax benefits would be applicable. However, if you have availed of the plan after February 2021, the plan is subject to the new ULIP taxation norms. 

Investing in ULIPs: Good or bad?

Also Read: Should You Buy ULIP? Find Out

ULIP taxation in India has seen a phenomenal change. It may seem less appealing to investors, given the new tax regime. However, ULIP continues to be an attractive option to those who are looking at long-term investment-cum-insurance products, especially because of its unique tax advantage on switching between equity and debt without any implications of capital gains tax. 

ULIPs are a good way to plan for needs that are likely to arise ten or more years in the future, such as children’s education or one’s retirement. It is ideal for those who need a certain hedge and conservative approach wherein the insurance part ensures that the milestones are achieved even in the event of the death of the insured.