How is your insurance policy taxed?

Some of us may be hoarse from shouting about why tax benefits should not be the reason we buy insurance. Shouting notwithstanding, tax treatment remains a key consideration when buying insurance of almost any sort and this is what we look at in this article.  

There are two points in time when the tax aspect will have to be kept in mind: 

1. First, at the time of premium payment
2. Second, at the time of a payout in the form of a claim being met or maturity benefits being paid out.  

This article deals with the tax treatment under the Income Tax Act, 1961 and does not cover GST on the premium.

Health Insurance

On premium payments: With respect to premium on a health insurance policy, section 80D of the Income Tax Act, 1961 kicks in. It says that the following can be deducted when calculating your total income for tax purposes:

• Health insurance premium for self and family (spouse and dependent children) including cost of preventive health checkup up to an aggregate of Rs. 25,000 with a cap of Rs. 5,000 for the preventive health check-up.
• Health insurance premium including cost of preventive health check-up for parents up to an aggregate of Rs 25,000 with a cap of Rs 5,000 for the preventive health check-up.
• In both the above cases, the available deduction goes up Rs. 50,000 if the insurance is on the health of a senior citizen (age >60 years) but the limit for preventive health check-up remains the same at Rs. 5,000.  

While the health check-up can be paid for by any mode (including cash), the health insurance premium will not be eligible for deduction if paid for by cash. (This document explains with examples how health insurance premium is treated). 

None of this is applicable if you opt for the new tax regime wherein you forego deductions under section 80D.

On payouts: The payouts from health insurance premium in the event of a claim, whether paid directly to the hospital (as in the case of a cashless cover) or reimbursed to the insured, is not taxed as it is not an ‘income’ for you but reimbursement of an expense. 

At PrimeInvestor, we strongly advocate having a good health insurance plan to protect your finances, tax benefit or no tax benefit. Check out our recommended list of health insurance policies at Prime Health Insurance. To learn more about the basics of health insurance, you can find some handy articles at Prime Varsity. 

Pure Term Insurance

Term plans are the simplest way (and our preferred way at PrimeInvestor) to get life cover without combining it with other investment goals. Because these are simple insurance products, (you pay regular premiums based on your age, health, occupation etc. and in the eventuality that the insured dies, the insurer makes a payout of the sum assured to the nominee), if the insured outlives the term plan, no payout is made. Because they are purely insurance products, term plans are also cheap. 

On premium payments: The premiums paid on a term plan are eligible for deduction from total income under section 80C of the Income Tax Act, 1961 (if you opt for the old regime that is). Do note that the aggregate of deduction via all eligible avenues claimed under sections 80C, 80CCC and 80CCD is capped at Rs. 1,50,000 as per section 80CCE of the Income Tax Act, 1961.

If policy is terminated within 2 years of commencement of insurance in the case of a single premium policy or in any other case before premiums have been paid for 2 years then deductions claimed will be added back and taxed.

On payouts: Since payouts under a pure term plan are only made on the death of the insured, it is not taxable according to the provisions of section 10(10D) of the Income Tax Act. Section 10 lists out items that are not included in total income and this is one of the items, subject to the following conditions: 

• Premium should not exceed 20% of capital sum assured for policies issued before 31.3.2012. 
• This is 10% for policies issued on or after 1.4.2012. 
• For policies issued after 1.4.2013 and insurance is on the life of a person with disability or severe disability as per section 80U or suffers from diseases specified under section 80 DDB, this limit is 15%.
• These conditions are applicable to claim a deduction under section 80C as well.

Here too, like in the case of health cover, we think a term plan is essential (except in some cases) irrespective of the tax benefits you get. If you are in the market for a term plan, take a look at Prime Term Insurance, our term insurance ranking tool. This tool will help you choose the best plan for you. For more information on the basics of term insurance, head to our collection of articles at Prime Varsity.

ULIP

A product that is notorious for mixing insurance and investment is the ULIP. ULIPs usually combine life insurance with an investment. Therefore, the ‘premium’ that is paid goes to towards various buckets:  One to secure the cover, two toward the investment component and then to the various charges involved in the plan. Unless the product is a single premium policy, the premium payment term will usually not be less than 5 years. To read more about ULIPs and how they stack up against mutual funds, read our article ‘ULIP vs. Mutual Fund’.

On premium payments: Premium payments under a ULIP are eligible for deduction under section 80C of the Income Tax Act. This covers premium paid for individual, spouse and children without specifying if dependent or not. As with term insurance premiums, ULIP premiums also fall under the Rs 150,000 limit.

On payouts: Payouts from ULIPs fall under the purview of section 10(10D) of the Income Tax Act (Incomes which do not form a part of total income). But this doesn’t mean that all ULIP payouts are exempt from tax. This was earlier the case as long as premium does not exceed 10% of capital sum assured for ULIPs issued after April 1, 2012) and this meant that ULIPs were getting the dual benefit of exemption at the time of premium payment and at the time of payout. This was however recently changed as follows:

• With effect from February 1, 2021, this blanket exemption was modified to be available only to ULIPs issued before February 1, 2021.
• For ULIPs issued after the above date, the exemption would only be available if the premium for such policy is under Rs 2,50,000 per year.
• Further, if premium is being paid for more than one ULIP, then the exemption will be only available for the policies where the aggregate premium does not exceed Rs. 2,50,000 for any of the previous years during the term of any of those policies. 
• None of these limits are applicable if the payout is on account of the death of the insured where the payout is not taxable. 
• This circular, explains with examples how and when ULIPs are taxable.
• In addition, the gains on the high premium ULIPs (over Rs. 2,50,000 issued after February 1, 2021) will be taxed in accordance with this notification which treats the gains like gains on equity mutual funds. Accordingly, capital gains will be calculated as follows: amount received for the first time as a payout on a ULIP including bonus allocations less aggregate of premium paid during the term of the specified ULIP till date of receipt of the amount. This amount will be deemed to be capital gains arising from transfer of a unit of equity oriented funds set up under a scheme of an insurance company comprising ULIPs. 

At PrimeInvestor, our house view is that it is better to combine a term plan with mutual fund investments than to go for a ULIP that combines it for you.

Annuity plans for pension

An annuity plan is a contract between you and the insurer where in exchange for payment(s) you make now or up to a certain point in time, you are assured of a lump sum or series of payouts in the future, usually once you are retired. They can be of different types – immediate annuity (where you make a lump sum payment in exchange for periodic payouts starting immediately) or deferred annuity (where you commit to contributing to the plan over several years in exchange for payouts that start at a point in time in the future). 

Annuity plans come under the purview of sections 80C and 80CCC of the Income Tax Act 1961. 

On premium payment: Any payment made to LIC or other insurer toward an annuity plan for the purpose of receiving pension payments in the future, by an individual, will be eligible for deduction from computation of total income. 

However, this deduction is clubbed with all the other items eligible for deduction under sections 80C and 80CCD with an aggregate cap of Rs. 1,50,000. 

Deduction (if you opt for the old tax regime), will only be available in the year in which contribution is made. If for instance it is an immediate annuity plan where you pay a significant sum of money up front, deduction will only be available in the year in which you make the payment – which will in all likelihood be far greater than the Rs. 1,50,000 limit. 

Deduction is not available to bonus or interest that has accrued and been credited to the account. 

On payout: But when it comes to payouts in the form of pension (pension payout or on account of surrender of the plan), these cannot escape being taxed. As they are income, they will be taxed at the rates applicable to you. 

Life Insurance with investment

Under this section, we will cover all other combinations of life insurance and investment that are not ULIPs or annuities. This would cover popular savings cum insurance products (such as endowment plans, guaranteed return cum insurance products, savings cum insurance products, money back plans). 

On premium payments:

• Under such products, by virtue of the life insurance component, you will be able to get a deduction under section 80C to the tune of the premium paid in that year. 
• This however falls under the overall cap of Rs. 1,50,000 including all the items under section 80C, 80CCC and 80 CCD and is subject to you opting for the old tax regime. 

On payouts: When it comes to payouts from life insurance policies, this falls under the purview of section 10(10D) of the Income Tax Act which says that payouts from life insurance policies do not form part of total income (i.e., they are tax-exempt), subject to the following:

• as long as premium in any year does not exceed 20% of sum assured for policies issued between 1.4.2003 to 31.3.2012 and 10% of sum assured for policies issued after 1.4.2012
• 15% in case the policy is on the life of a person with disability / severe disabilities or specified disease or ailments for policies issued after 1.4.2013. 
• These limits are applicable to claim a deduction under section 80C as well.
• These limits shall not be applicable if the payout is made on the death of a person. 

But here is the catch. Once the changes proposed by Budget 2023 kick in, these policies will not enjoy the blanket tax-free status that they now do. We have covered this change in our article on the key changes proposed by Budget 2023. So from April 1, 2023, here is what will happen.

While proceeds received on death will continue to be tax-free other payouts will only be tax free if they meet the following criteria in addition to what is already laid out in section 10(10D) mentioned above:

• The yearly premium should be less than Rs. 5 lakhs. 
• To plug the loophole of individuals investing in multiple policies with premiums less than Rs. 5 lakhs, premium will be calculated at the aggregate level (all such policies you hold, put together), and not per policy. 
• This provision affects only fresh policies issued and not existing policies and will take effect from April 1, 2023. 

This will now be taxed under the head ‘Income from Other Sources’ where the only exemption applicable is the purchase price, provided that hasn’t been claimed under any other provision of the act. Essentially, the proceeds will be added to your income to compute your total taxable income and your tax slab.

To understand in detail how payouts from life insurance policies will be taxed post Budget 2023 head to our article ‘Payout from a life insurance policy – when is it tax exempt and when is it not?‘ that breaks down the CBDT guidelines for the same.

Summary

Here’s a quick view of all the provisions that we have explained above, for your reference.