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How life insurance policies are taxed?


In very simple terms, Life insurance is a contract that you enter into with an insurance company. You, the policyholder, pay periodical premiums to the insurance company in exchange for a gross amount payable on the death of the insured (death benefit) and/or on completion of the insurance term (maturity benefit).

Tax Benefits on Life insurance policy

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

Let’s understand the two clauses that affect life insurance-related taxes –

Section 80 C

Any resident or non-resident individual can claim a deduction for the life insurance premium paid under Section 80 C up to 1.50 lakh every year. This deduction is available along with other eligible items like PPF, NSC, ELSS, fixed deposits, home loan repayment, tuition fee paid, provident fund contribution etc.

You can only claim an 80C exemption for life insurance premiums upto 10% of the sum assured. For any premium paid over 10%, the deduction is not available. However, for certain individuals who are classified as handicapped persons or suffering from critical illness, upto 15% of the sum insured is exempt, capped at INR 1.5 lakh per year.

Section 10 (10D)

Section 10 (10D) of the Income-tax Act decides whether the maturity proceeds of your life insurance policy will be tax-free or not. Section 10(10D) is applicable to any amount paid out under the insurance plan; whether it is a death benefit, maturation of the plan, or other bonuses.

An 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 premium paid.

For Life insurance plans bought after April 1, 2012, according to section 10 (10D), if the annual premium paid is more than 10% of the sum assured of the policy, the maturity proceeds (survival benefits) would be taxed, according to your income tax slab. If not, then the proceeds are tax-free.

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

For certain individuals, who meet the following criteria:

1. Disabled or severely disabled persons as specified under Section 80U of the Income Tax Act, 1961.

2. Individuals suffering from ailments as specified under Section 80DDB of the Income Tax Act, 1961.

3. Maturity benefits are not taxed if premiums do not exceed 15% of the sum assured for plans bought before April 1, 2013.

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

1. Tax deductions under Section 10(10D) are available for life insurance claim payouts such as death benefits and maturity benefits, including accrued bonuses.

2. Tax deductions under Section 10(10D) are applicable to all types of life insurance claim payouts.

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

4. Deductions are applicable to both foreign as well as Indian life insurance companies.

ULIP taxation

The benefits of section 10(10D) also apply to any gains accruing out of Unit-Linked Insurance Plans (ULIPs), and Single Premium Life Insurance Policies (if the aforementioned conditions are met).

As a quick refresher, ULIPs are policies where you pay the premium for a certain number of years(usually around 5), which the insurer invests for you, along with offering a life insurance cover (usually for a sum insured of 10 lakhs). After the premium payment term is over, there is a holding period (eg: 5 more years) and then you receive a maturity benefit. So one example of a ULIP is one where you pay 1 lakh a year for 5 years, and 5 more years later, the insurer returns to you a lump sum of 10 lakhs*. If you pass away in this time frame, your beneficiaries receive an additional death benefit of INR 10 lakhs.

*This sum is just for illustration, ULIPs are linked to equity and debt markets and returns will vary.

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

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

If the annual premium paid towards the ULIP is greater than INR 2.5 lakhs, then there is no tax exemption on the returns. Any taxable returns are treated as capital gains (not income tax). 

Let us look at some examples –

Example 1

As an example, let’s say you purchase a ULIP on 2nd April 2021. Every quarter you pay a premium of INR 65000. You pay for 5 years, and for 5 more years after that, the money is invested by the insurer, who then pays you your maturity benefit of INR 21 lakhs on 2nd April 2031. The policy had a life sum insured of INR 15 lakhs(in case you pass away in those 10 years, your family will get 15 lakhs).

You can claim an income tax exemption of 1.5 lakh as per the 80C limit, for every year that you pay the premium. On the maturity amount of 21 lakhs, you will not be able to claim any tax deductions, as your annual premium is 65000×4=2.6 lakhs. Because your annual premium paid is above 2.5 lakhs, no exemption is given on your returns, and they will be taxed as long-term capital gains(LTCG).

In the unfortunate event of your demise in these 10 years that the policy was active, your family would receive the 15 lakh death benefit sum insured completely tax-free. However, at the end of the 10 years, when the maturity benefit comes through, the 21 lakhs will still be taxed as long-term capital gains as the annual premium was more than 2.5 lakhs.

Example 2

Let’s now take another example where you took a ULIP, on 2nd April 2021. You pay 1 lakh a year for 5 years, and for 5 more years after that, the money stays invested, until the insurer pays a maturity benefit of INR 12 lakh on 2nd April 2031. The policy has an INR 5 lakh life insurance cover in case you pass away in the 10 years that the policy is active.

Even though you pay a premium of 1 lakh, you can only claim INR 50,000 as a section 80 income tax exemption. This is because the life sum assured(aka sum insured) is INR 5 lakh, and you can only claim 10% of that as income tax exemption in the 5 years that you pay the premium.

The maturity benefits, however, are entirely tax-free as the annual premium you pay is less than 2.5 lakhs.

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

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


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