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To optimise available tax benefits, we should know when exemptions kick in and when they don’t.
A life insurance policy acts as a cushion for your family should something tragic happen to you, especially if you are the sole breadwinner. A unit-linked insurance plan (ULIP) does much the same, but it is also an investment tool in itself, while a pension fund ensures a nest egg for your old age.
However, financial stability is not the only common denominator here; you should also be aware of the tax liability involved. We are told of the tax exemptions we can avail of on a life insurance policy, but did you know that under certain conditions, insurance maturity proceeds are also taxable, as are your ULIP investments?
Similarly, are you aware that when you receive the annuity on your pension fund after your retirement, it will be taxed?
So, in order to take advantage of the tax benefits that are offered to us when we invest in any of these three options, we should be aware of when tax exemptions kick in, and when they do not. Therefore, it becomes necessary to look at the various ways life insurance and pension policies are taxed on maturity, and also break down how tax proceeds on these plans should be reflected in our income tax returns.
Life plan exemptions
If you are a life insurance policyholder and want to claim deduction under Section 80C of the Income Tax Act on the premium you have paid, check when your policy was bought: if the policy was bought before 1 April 2012, the premiums should not be more than 20% of the sum assured, and not more than 10% if the purchase was after 1 April 2012.
Some life insurance policies cover a disability explained under Section 80U (blindness, leprosy-cured etc.) or a disease spelled out under Section 80DDB (AIDS, cancer etc.); here, the premium should not exceed 15% of the sum assured and the policy must have been purchased after 1 April 2013.
This apart, you will not be required to pay tax on any amount you receive when your life insurance policy matures, or on any amount you are paid as bonus; these earnings are exempted under Section 10(10D), subject to certain conditions.
As you may have guessed, Section 10(10D) deals with tax exemptions allowed by the Income Tax Act, and it exempts any amount received under a life insurance policy, including the sum allocated in the form of bonus on such policy.
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Single premium exemptions
There is also something called the ‘single premium policy’; this is when the policyholder pays a lump sum as premium instead of opting for the yearly, quarterly, or monthly payment periods.
People typically opt for a single premium policy when:
- They have a lump sum available and are seeking a safe investment avenue;
- They want to make a ‘last-minute investment’ before the close of a financial year so as to maximise tax saving benefits;
- They want to avoid the hassle of periodic payments.
Tax benefits for single premium policies is more or less on par with that of regular policies, with the premium paid being eligible for tax deduction under Section 80C, and the maturity amount being tax-free under Section 10(10D).
However, Section 10(10D) also states that for such plans, the premium should not be more than 20% of the sum assured for tax benefits to accrue. So, for a life cover of Rs 1 lakh, the premium should not exceed Rs 20,000.
Related: Single premium vs regular premium products in insurance. Which scores higher?
Life plan and TDS
So far, we have been discussing the tax-saving aspect of life insurance. However, under Section 194DA, certain amounts received under a life plan may be subject to TDS (tax deducted at source), but bear in mind that TDS is not applicable if the aggregate payable amount is within Rs 1 lakh.
Section 194DA says any person responsible for paying any sum under a life insurance policy, including the sum allocated by way of bonus, shall deduct income tax if these amounts are not included in the total income under section 10(10D).
So, a payment to a resident Indian upon maturity of a life insurance policy will be subject to TDS under Section 194DA, and the deduction amount will be 5% of the income in the case of individuals and 10% in the case of companies. However, TDS will be at the rate of 20% if the payee does not submit PAN details to the payer.
Related: Important things to know about paying life insurance premium
Tax exemptions can be disallowed in certain situations; for instance, any money received from a life insurance policy is fully taxable if the premium is more than 10% or 20% of the sum assured, as the case may be.
This is as per section 80C(3A), which states that only the premium paid on insurance policy – which is not in excess of 10% of the actual capital sum assured – is eligible for deduction.
For policies that cover a disability disease, when Section 10(10D) comes into play, policy proceeds will be taxed if any of the following three scenarios play out:
- First scenario: The premium payable in any year exceeds 20% of the actual sum assured in case of such policies issued between April 1, 2003 and March 31, 2012. (The ‘actual sum assured’ refers to the least sum assured in all the policy years and excludes any bonus amount that is to be received over and above the assured amount. It also excludes any premium that is to be returned to the policyholder.)
- Second scenario: For policies issued on or after 1 April 2012, the limit of 20% in the first scenario will come down to 10%. However, in case the insured suffers from severe disability or specified diseases mentioned earlier, this limit will be 15%.
- Third scenario: In a situation when the premium payable exceeds the prescribed limit percentage (10%, 15%, or 20% of actual sum assured), all policy proceeds would be taxed. However, this will be exempted if the policyholder dies – that is, their nominee(s) will not be liable to pay tax on any amounts received.
Related: Why is Life Insurance one of the most preferred Investments with benefits
Single premium taxation
A single premium life insurance plan can leave taxpayers unsure of whether the policy proceeds are taxable or not. As stated earlier, in such plans, a single premium amount can be no more than 20% of the sum assured; if it exceeds the specified limit, maturity proceeds will be not be entitled to exemption under Section 10(10D) and will be taxed at 5% of the income component of the payment.
ULIPs are invested in debt and equity funds, and returns depend on the performance of the fund. And like a few other long-term investment vehicles such as PPF or EPF, it is categorised as an EEE (Exempt-Exempt-Exempt) tax-saving instrument.
EEE means it enjoys three different tax exemptions:
- The first E implies plain vanilla tax exemption (premiums are deductible from taxable income under Section 80C up to Rs 1.5 lakh);
- The second E signifies exemption of taxes on interest earned during the accumulation phase;
- The third E implies tax exemption during withdrawal of income generated from the investment.
Investors find ULIPs attractive because of the tax advantage ensured by Section 10(10D), as well as the prospects of higher returns in equity investment.
Related: What happens on surrendering a Ulip
ULIP taxation details
The annual budget for 2021-22 has now proposed that gains from a ULIP policy be treated as capital gains when the premium exceeds Rs 2.5 lakh, and set a tax rate at 10% on maturity.
Tax on ULIP is not a new thing; despite the tax benefits under an EEE regime, ULIPs till now came under the tax ambit when the sum assured was more than 10 times the annual premium. However, the budget proposal is an attempt to bring about parity between ULIPs and mutual funds.
This is because, as compared to ULIP’s tax rates, mutual funds attracted 10% long-term capital gains tax on gains over Rs 1 lakh if the holding period is more than one year, and 15% short-term capital gains tax for shorter periods.
The new proposal pertains to all ULIP policies issued after 1 February 2021. In other words, investors already paying premiums of over Rs 2.5 lakh a year will continue to enjoy tax exemption under the old regime.
Related: ULIPs: 8 Charges you must know before investing
Tax sop reversals
Any tax benefit availed of on premiums paid in earlier years under Section 80C can be reversed for life insurance policies as well as ULIPs, if:
- Single premium policy has not been held for at least two years;
- Premium has not been paid at least two years in case of traditional policies;
- Premium has not been paid for at least five years in case of ULIPs.
Pension plan exemptions
Pension plans or retirement plans can be broadly divided into two stages: the accumulation stage and the vesting stage.
- Accumulation stage: This is when you pay annual premiums until you reach the retirement age;
- Vesting stage: This begins with retirement, when you start receiving annuities, which will continue as long as you live, and end with the death of your nominee – assuming he or she outlives you.
Contributions of up to Rs 1.5 lakh in a pension plan are tax-exempt under Section 80CCC. This includes the amount spent on buying a new pension plan or renewing an existing one.
Also, while both residents and non-resident Indians can claim tax deductions offered by this section, Hindu Undivided Families (HUFs) are not eligible.
Pension plan tax
As indicated in the previous section, tax exemption is only up to a certain limit; this means withdrawals are not totally tax-free, and only a third of the corpus given to you after you reach the retirement age is exempt. The remaining amount is distributed as an annuity and is subject to taxation as per your tax slab at the time of retirement.
Related: Types of pension plans and their tax benefits
If you are talking of tax and exemptions, can the income tax return (ITR) be avoided? No, because if you have net maturity proceeds from your life insurance policy or ULIP, you have to report it in your ITR filing – under ‘Income from other Sources’ in Schedule EI in ITR forms 2, 3, and 4, and under ‘exempt income’ in ITR Form 1. And naturally, to claim the credit for TDS against your tax liability, you need to file your ITR. Here's a guide to filing your income tax return on your own.