The Central Board of Direct Taxes (CBDT) had issued a notification in August 2023, inserting a new tax rule—11 UACA— for calculation of the proceeds of life insurance plans under section 56(2)(xiii) of the Income Tax Act, 1961. It shared 13 examples to shed light on the same. However, all these examples factored in only the lump sum payout on the maturity date. It did not explain scenarios where regular income or survival benefits are paid across multiple years.
Some insurance industry experts claim that such plans are currently being sold on the premise that payouts will not be taxable unless the aggregate premiums paid during the premium payment term get adjusted against it. To deduce this, we have taken the case of a non-linked, non-participating savings plan of an insurance company for a 25-year policy period subscribed to by a 54-year-old individual from a leading life insurance company. The annual premium to be paid in this case over a period of 10 years is Rs25 lakh and payouts start from the 11th year onwards. The payout is fixed at Rs31.34 lakh for 15 years. Should the annual payout of ₹31.34 lakh be taxable since the annual policy premium is more than Rs5 lakh? Of course, yes! But all the payouts will not be taxable.
This is what the CBDT notification says: If the taxpayer has received the payout from such life insurance policy for the first time, then the income chargeable to tax shall be taken as A-B; where A is the amount received, including the amount allocated by way of bonus, and B is the aggregate of premium paid during the term of such policy, till the date of receipt of such sum that has not been claimed as deduction under any other provision of the IT Act.
Naveen Wadhwa, vice president, research and advisory, Taxmann, says the first payout will not be taxable as the aggregate premiums paid in previous years are higher than the annual payout.
What about the second payout?
The CBDT notification says if the taxpayer has received the sum under the life insurance policy for second and subsequent times, then the income chargeable to tax shall be C-D, where C is the amount received during the subsequent FY; and D is the aggregate of premium paid during the term of the policy till the date of receipt of the sum in the subsequent fiscal year (FY) not being premium which has been claimed as deduction under any other provision of the IT Act or is included while computing income in earlier years.
“The second and subsequent payouts will not be taxable either until Rs2.5 crore (Rs25 lakh multiplied by 10) has been paid back,” Wadhwa says.
Between the first and seventh payouts beginning from the 11th year, a sum of Rs2.19 crore premium will have been adjusted. In the 18th year, ₹30.61 lakh premium (Rs2.5 crore minus Rs2.19 crore) will need to be adjusted against the 8th payout. So, a sum of ₹73,024 (Rs31.34 lakh- Rs30.61 lakh) will get taxed at the individual slab rate. Do note that Rs31.34 lakh is the annual payout mentioned earlier in this story. Payouts from the 19th year onwards will be fully taxable.
“In a life insurance policy, due to the specific language of the tax laws, the income is to be computed only for actual receipts in excess of the premium paid. Therefore, payouts by the insurer are to be first adjusted against the premium payments, and no income arises till the premium payments are fully adjusted,” says Gautam Nayak, a chartered accountant and partner at CNK & Associates LLP.
Going by this interpretation, the tax liability is deferred, unlike other financial instruments where capital gains are taxed in the same year when booked. These products being long-term in nature, the slab rate of the policyholder may very well change after he or she retires. Take the case of mutual funds. Assume that you invest Rs10 lakh in an equity mutual fund and it grows to Rs31 lakh after 10 years (12% CAGR, or compound annual growth rate). At this stage, you withdraw one-fourth of your investment (Rs7,70,000). This withdrawal is considered as part principal and part capital gain. The withdrawal is treated in this manner even though the withdrawal is less than the principal invested. An amount of Rs5,23,194 will be taxed as long-term capital gains.
Prakash Hegde, a chartered accountant with Acer Tax & Corporate Services LLP, Bengaluru, says one should not assume that the tax will be deferred in life insurance plans because the circular is unclear about it. “In case of an annual premium of Rs25 lakh, what were to happen if a tax official asks for deduction of Rs25 lakh every year from the first 10 payouts and says the remaining amount is taxable each year? Payouts after 10 years will be fully taxable. CBDT would do well to clarify the taxation of such multiple pay-out plans,” says Hegde.
“It is to be noted that if someone claims Section 80C deduction of up to Rs1.5 lakh on the premium paid, this will be deducted from the annual premium when computing the taxable maturity,” says Wadhwa. It means if the annual premium is Rs25 lakh to be paid over 10 years and Rs1 lakh deduction is sought under section 80C every year, only Rs2.4 crore will be adjusted against the payout to compute the taxable maturity.
Hegde further highlights an unexpected relaxation provided in the CBDT circular. “In case someone buys three policies of Rs2 lakh annual premium maturing in different years, maturity proceeds in none of the policies will be taxable even though the aggregate premium has exceeded Rs5 lakh,” he says. It means splitting premiums among different traditional plans where annual premiums are below ₹5 lakh each, and ensuring that maturity dates fall in different financial years, fetching tax exempt maturity in each is possible. However, if the three policies mature in the same year, one of them will get taxable. “The taxpayer is free to choose the one with the lowest tax liability,” Hegde says.
Mint take
Whatever premium-payout combination one designs, the point remains that the internal rate of return (IRR) in traditional life insurance plans tends to be poor. With tax angle at play, the IRR comes in even lower. We calculated it for HDFC Life Click 2 Achieve and Tata AIA Life Insurance Fortune Guarantee. The annual premium amount remains the same in both plans for a 54-year-old, but the premium payment term and payout period differ. The amount of payout differs too. The post-tax IRR, however, remained the same at nearly 4%. Consult your investment and tax advisor before buying such plans.