Investors often focus on tax benefits. What about the insurance payout? Is it taxable or exempt? Tax on insurance payouts could lower potential returns with repercussions for future income and lifestyle.
Let’s look at the product-wise taxability of insurance payouts:
Term life cover
In a term life policy, premiums are paid to seek a pure life cover. On death, an amount equivalent to the sum assured goes to the beneficiary. As per Sec 10 (10 D) of the Income Tax Act, the beneficiary can receive the entire sum assured without having to pay any taxes on it. Moreover, there are no limits on the claim amount.
Health and critical illness cover
Let’s suppose you have a health cover and make a claim for medical treatment in a hospital. In this case, the claim amount received will not be taxed as it is only reimbursement of your medical expenses and not income or profit for you.
In short, for pure insurance covers, almost all money transfers made for claims made by the beneficiary are fully exempt from taxes.
However, investment-oriented insurance products have a different tax treatment. And that’s because sec 10 (10D) has some exceptions.
Case 1: If your policy was bought after 1st April 2012, and the premium paid is more than 10% of the sum assured
Let’s suppose an individual bought a policy in 2016. He pays an annual premium of Rs 30,000 on the policy with a sum assured of Rs 2 lakh. Since the annual premium paid is more than 10% of the sum assured (Rs 20,000), monetary receipts will be subject to taxes at the marginal rate.
Here’s what you need for the calculation of taxable income. You need to deduct the premium paid, over the years, from the maturity proceeds. Include bonuses if any. Such income gets classified as ‘income from other sources’ for the purpose of taxation.
In contrast, if the annual premium is less than 10% of the sum assured, there are no taxes. For those with a disability or a disease, the premium threshold is relatively higher at 15% of the sum assured.
Case 2: If your policy was bought before 1st April 2012, and the premium paid is more than 20% of the sum assured
Here too, taxes will be applicable on maturity proceeds, like in this case. So, if you have an old policy (bought before April 2012), remember that it is 20% and not 10% of the sum assured that you need to consider.
NAV gains from investing in ULIP are exempt from income tax under Section 10(10D). However, not all ULIPs will get the exemption thanks to IRDA regulation (of October 2019), which reduced the minimum sum assured requirements for ULIPs from 10 times to 7 times of its annual premium.
And to get Sec 80C benefits on ULIP investments, the premium should be at least 10 times the sum assured.
In short, ULIP policyholders need to have a minimum sum assured of 10 times. This is if they want to take advantage of both tax deductions and exemptions under Sec 80 C and Sec 10 (10D) respectively.
The minimum sum assured for single premium policies was also mandated by IRDA to be 125% of the single premium. While it qualifies for sec 80 C benefits, it is also ineligible for sec 10(10D) benefits since it crosses the 10% threshold.
In a retirement plan, on the vesting date, the entire retirement corpus cannot be fully withdrawn.
An insurer might allow up to 1/3 rd of the accumulated corpus to be withdrawn as lump sum. The remaining generates a steady cash flow in the form of an annuity. While the lump sum received is not taxable, pension income is taxed at a marginal rate.
In case of applicable taxes on maturity amount, section 194DA becomes applicable. TDS at the rate of 5% is deducted from the proceeds by the insurer. However, proceeds up to Rs 1 lakh are exempt from TDS.
In the financial year 2020-21, in order to ease the financial pain of policyholders, the government reduced the TDS rate from 5% to 3.75%.
Since pure insurance policies have a relatively lower premium (than investment products) as a percentage of sum assured, most qualify for tax exemption under sec 10 (10D). It makes financial sense to separate your insurance needs from that of investment.