It’s been a year since the tax advantage for high-premium traditional life insurance policies ceased to exist, leading to a decline in their appeal among high net-worth individuals (HNIs). However, the insurance industry has found a workaround. They’re promoting the seemingly innocuous loan feature in these policies as a means to sidestep tax obligations on maturity proceeds.
For the uninitiated, traditional life insurance policies issued on or after 1 April 2023, with an annual premium exceeding ₹5 lakh, incur tax on their maturity or survival benefits. Death benefits, however, remain untaxed. Essentially, if you’re paying ₹6 lakh annually for such a plan, the maturity payout is subject to taxation at your income tax slab rate. The total premiums paid are deducted from the maturity amount before determining the tax liability at your slab rate.
Earlier popular among HNIs, these plans are struggling to attract buyers. But industry experts say that insurers have found a loophole to market them anew, suggesting clients leverage the loan provision against the policy’s cash value. Here’s where the strategy lies: clients can borrow 90-95% of the survival benefit, tax-free. Loan cannot be taxed. The remainder stays with the insurer.
“This is how they are pitching it to customers. They say that the interest income on this amount will get set off against the interest rate on loan and policyholders do not have to pay interest on the loan amount,” said an insurance executive on the condition of anonymity.
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This sales tactic primarily targets whole-life insurance plans, where death benefits extend for the policyholder’s lifetime up to 100 years. “In case of a death of the policyholder, the 90-95% benefit that has been withdrawn as a loan will be deducted from the death benefit and be given to the beneficiary,” the executive said.
However, CA Sambhav Daga cautions that interpretations of Section 10(10D) of the Income Tax Act regarding “any sum received under a life insurance policy” could vary.
“If the word received is taken in its literal sense, no tax issue will arise if you take the loan against the survival benefit. However, if the word received is to be taken in the context of accrued benefits, you may have to pay tax on it,” said Daga.
Additionally, the interest rate on loans against insurance policies is set at Reserve Bank of India bank rate + 1%, compounded annually. The rate is the same for the interest earned by the insurance company, but it does not compound.
“Due to the compounding of interest payable on loan and non-compounding of interest on money accrued with the insurance company, the policyholder will definitely lose some money,” Daga pointed out.
Moreover, insurers retain the authority to adjust outstanding loan amounts and accrued interest against death benefits or surrender values, a detail explicitly outlined in policy documents.
Mint take
Taking loan instead of maturity seems to be a smart loophole to circumvent the tax liability under Section 10(10D) of Income Tax Act. However, customers would do well to consult their tax advisors before acting on the sales pitch by distributors. Life insurance policies entail long-term commitments, and the efficacy of this tax loophole may evolve before policyholders can capitalize on it.