How are life insurance policies taxed?

In very simple words, life insurance is a contract that you enter into with an insurance company. You, the Policyholder, pay periodic premiums to the Insurance Company in lieu of the aggregate amount payable on the death of the Life Assured (Death Benefit) and/or on completion of the Insurance Term (Maturity Benefit).

Tax Benefits on Life Insurance Policy

Life insurance policies not only provide maturity/death benefits, but also tax deductions under section 80C and section 10(10D) of the Income Tax Act, 1961.

Let us understand the two sections affecting the taxes related to life insurance –

Section 80C

Any resident or non-resident person can claim deduction for life insurance premium paid under section 80C 1.50 lakhs every year. This deduction is available along with other eligible items like PPF, NSC, ELSS, Fixed Deposit, Home Loan Repayment, Tuition Fees Paid, Provident Fund Contribution etc.

You can claim 80C exemption only for life insurance premium up to 10% of the sum assured. For any premium paid in excess of 10%, deduction is not available. However, for certain persons who are classified as disabled persons or suffering from critical illness, there is a rebate of up to 15% of the sum insured, limited to Rs 1.5 lakh per annum.

Section 10 (10D)

Section 10(10D) of the Income Tax Act decides whether the maturity amount of your life insurance policy will be tax-free or not. Section 10(10D) applies to any sum paid under an insurance plan; Be it the death benefit, maturity of the plan, or other bonuses.

One important thing to remember is that death benefits are always tax-free. Maturity benefits (paid on survival for a certain time period) are sometimes taxed based on the premiums paid.

For life insurance plans purchased after 1st April 2012, as per section 10(10D), if the annual premium paid exceeds 10% of the Sum Assured of the policy, then maturity proceeds (survival benefit) will be charged to tax. Your income tax slab. If not, the income is tax free.

For life insurance policies issued between 1 April 2003 and 31 March 2012, the premium should be less than 20% of the Sum Assured to avoid taxation.

For certain individuals who meet the following criteria:

1. Disabled or severely handicapped person, as specified under section 80U of the Income Tax Act, 1961.

2. Person suffering from specified diseases under section 80DDB of the Income Tax Act, 1961.

3. Maturity benefits are not taxable if the premium does not exceed 15% of the Sum Assured for the plan purchased before 1st April, 2013.

Eligibility Criteria for Section 10(10D) of Income Tax Act

1. Tax deduction under section 10(10D) is available for life insurance claim payments such as death benefit and maturity benefit, including accrued bonus.

2. Tax deduction under section 10(10D) is applicable on all types of life insurance claim payments.

3. There is no upper limit on the tax benefits available under section 10(10D) of the Income Tax Act.

4. The deduction is applicable to both foreign and Indian life insurance companies.

ULIP Taxation

The benefits of section 10(10D) also apply to unit-linked insurance plans (ULIPs) and any benefit derived from single premium life insurance policies (if the above conditions are satisfied).

As a quick refresher, ULIPs are policies where you pay premiums for a certain number of years (usually around 5), which the insurer invests for you, plus a life cover (usually 10 for a sum insured of Rs. After the premium paying term is over, there is a holding period (eg: 5 more years) and then you get the maturity benefit. So an example of a ULIP is one where you pay 1 lac annually for 5 years, and after 5 years, the insurer returns you a lump sum amount of 10 lac*. If you die within this time frame, your beneficiaries get an additional death benefit of INR 10 lakhs.

*This amount is for illustrative purposes only, ULIPs are linked to equity and debt markets and returns will vary.

Traditionally, ULIP premiums were exempted under section 80C and maturity benefits were also exempt as per section 10(10D).

However, a new rule was introduced for ULIPs in 2021, which is applicable to ULIPs purchased on or after February 1, 2021. The rule is simple:

There is no tax exemption on the return if the annual premium paid for ULIP exceeds INR 2.5 Lakh. Any taxable return is treated as a capital gain (not income tax).

Let’s look at some examples –

Example 1

As an example, suppose you buy a ULIP on 2nd April 2021. Every quarter you pay a premium of Rs.65000. You pay for 5 years, and after that for 5 more years, the money is invested by the insurer, who then pays on April 2, 2031 you get a maturity benefit of Rs 21 lakh. The policy had a life sum assured of Rs 15 lakh (if you die in those 10 years, your family will get 15 lakh).

You can claim income tax exemption of 1.5 lakh as per 80C limit for each year you pay premium. On maturity amount of 21 lakhs, you will not be able to claim any tax deduction, as your annual premium is 65000×4 = 2.6 lakhs. Since your annual premium is more than 2.5 lakhs, there is no exemption on your returns, and they will be taxed as Long Term Capital Gains (LTCG).

In the unfortunate event of your demise in the 10 years that the policy was in force, your family will receive 15 lakh Death Benefit Sum Assured completely tax-free. However, at the end of 10 years, when the maturity benefit comes, 21 lakh will still be taxed as long-term capital gain as the annual premium was more than 2.5 lakh.

Example 2

Let us now take another example, where you took a ULIP on 2nd April 2021. You pay 1 Lakh per annum for 5 years, and after that for 5 more years, the money stays invested till the insurer pays a maturity benefit of INR 12 Lakh. On 2 April 2031. The policy has a life insurance cover of INR 5 lakhs in case you die within 10 years of the policy being in force.

Even if you pay a premium of Rs 1 lakh, you can claim only Rs 50,000 as section 80 income tax exemption. This is because the Life Sum Assured (aka Sum Assured) is INR 5 Lakh, and you can claim only 10% as Income Tax Exemption in the 5 years you pay the premium.

However, the maturity benefits are completely tax-free as the annual premium to be paid by you is less than 2.5 lakhs.

In general, separating insurance and investment is still better than the alternative, and yields better returns. A term life policy with a healthy investment portfolio usually gives better returns than a single life policy, while providing a significant life insurance cover for your family. If you value the simplicity and comfort of funds managed by advisors, then investment policies make sense for you, provided you stay within the tax exemption limit.

Author: Avinash Ramachandran, COO and Sunil Padasala, Chief Innovation and Strategy Officer, AssureKit