Prioritise insurance policies with higher maturity for tax exemption

This approach will minimise your tax liability on traditional policies with lower maturity proceeds

A new circular issued by the Income-Tax (I-T) Department provides greater clarity on the taxability of non-unit-linked (basically, traditional) life insurance policies. Prior to Budget 2023, a payout from any life insurance policy (other than Ulips) was exempt from taxation, provided a few specifications were met.

Says Pallav Pradyumn Narang, partner, CNK: “According to Section 10(10D), amended in the Finance Act of 2023, there is no tax exemption for life insurance policies issued on or after April 1, 2023, if the premium exceeds Rs 5 lakh.” An additional condition, which has been there for a long time, is that there is no exemption if the premium exceeds 10 per cent of sum insured.

Plugging tax leakage  

Under the old rules, maturity benefits enjoyed tax exemption irrespective of the premium amount. While the goal was to promote insurance penetration, these policies ended up becoming a tax-avoidance tool for high net worth individuals (HNIs) who bought high-value policies with hefty premiums. Says Ankit Jain, partner, Ved Jain & Associates: “Affluent individuals were drawn to these plans due to their guaranteed, tax-free maturity benefits coupled with insurance coverage. Observing this, the government introduced these amendments.”

Rules for multiple policies

If the aggregate premium of more than one policy exceeds Rs 5 lakh, only the policies with a combined annual premium of up to Rs 5 lakh will be exempt. Investors can choose the policies whose proceeds they want exempted. Narang clarifies that Goods and Services Tax (GST) applied on the premiums will not count towards the Rs 5 lakh limit.

Suppose that a new policy is purchased, say, on April 1, 2028, after the premium-paying term of an earlier policy has ended. The annual premium of the two policies exceeds Rs 5 lakh. Says Jigar Patel, member, Association of Registered Investment Advisors (ARIA): “The earlier policy may not have matured. Nonetheless, the maturity benefit received from both will be exempt. The key is that the annual premium paid on multiple policies should not exceed Rs 5 lakh.”

Term policies don’t make any payout if the insured survives the policy term. The premium of a term policy will not be counted towards the Rs 5 lakh limit.

Jain points out that any payout made to the nominee upon the policyholder’s death continues to be tax exempt. This is regardless of the nature of the plan.

How will tax be calculated in the case of policies where the payout is not exempt? Says Patel: “The premium paid can be deducted from the maturity benefit. However, indexation benefit is not available.” The net amount shall be taxed as income from other sources.

Says Sandeep Bajaj, advocate, Supreme Court of India: “These revisions provide lucid directives for claiming exemptions on eligible life insurance policies.”

HNIs to be impacted

The Rs 5 lakh threshold is reasonably high, so these changes will mostly affect HNIs.

Post April 1, 2023, taxpayers should be mindful while investing in traditional policies for tax-free returns. Says Archit Gupta, chief executive officer, Clear: “Make sure you do not cross the Rs 5 lakh premium threshold.” He adds that where the proceeds become taxable, the post-tax returns are likely to be sub-optimal. The pre-tax returns from these plans anyway don’t exceed 4-6 per cent. Taxation at slab rate will make their post-tax returns even less attractive.

If you are planning to change your payment frequency, think again. Says Bajaj: “If an individual alters her premium payment frequency within the policy term, such as shifting from annual to semi-annual or quarterly payment, resulting in the premium exceeding Rs 5 lakh, the maturity benefits of the policy will become taxable.”

Experts have always warned against mixing insurance and investment. Says Patel: “Buy term insurance for protection.” For investment, go with products like fixed deposits, mutual funds, etc.

For Ulips, the government had imposed a cap on the premium even earlier. So, ensure that for Ulips purchased on or after February 1, 2021, the aggregate annual premium does not exceed Rs 2.5 lakh.

Offer the traditional policies with higher maturity proceeds first for exemption and let the policies with lower maturity proceeds be subject to taxation.

Strategies for those holding multiple policies  

If the aggregate premium of multiple policies exceeds Rs 5 lakh, only the policies with annual premium up to Rs 5 lakh will be tax exempt (investor can choose the policies he wants exempted)
 

Suppose that a policyholder has five policies with annual premium of Rs 1 lakh (A), Rs 1.5 lakh (B), Rs 2 lakh (C), Rs 3 lakh (D) and Rs 4.75 lakh (E)
 

In this case, the investor may choose policy E for exemption (as premium is below Rs 5 lakh)
 

However, he should select policies C and D for exemption, as the maturity benefit from them is likely to be higher than from E
 

Source: ARIA