We’ve always said that one should buy an insurance product for precisely that – insurance. Yet one can’t deny that the taxation aspect too plays a part in the way we choose insurance products. But with the changes that have been coming into force, it is clear that the Government is trying to slowly but surely limit these avenues of insurance products being used to save on taxes.
It was high-value ULIPs, first, that were made taxable in 2021. The latest Budget proposed a similar restriction in tax-free status for non-ULIP life insurance products. (We discussed it briefly in our Budget update –Budget 2023 – Impact on your investments and the market’).
Just after Independence Day, the CBDT (Central Board of Direct Taxes) issued a 17-page guideline for this change. Here, we break it down to see what it means for you.
The tax change in any sum received under a life insurance policy
How payments received under a life insurance policy used to be taxed
Until Budget 2023, any sum received under a life insurance policy (non-ULIP), including the sum allocated by way of bonus, was tax free as long as it met the conditions laid down in section 10 10(D) of the Income Tax Act.
If you are wondering what section 10 of the Income Tax is all about, it deals with the various items that are not included in total income (therefore making it tax-exempt).
For a payout under a life insurance policy to be tax exempt, it needed to meet the following criteria:
- not be a payout received under 80 DD (3) or 80 DDA (3) – payout when a dependent with disability predeceases an individual;
- not be sum received under a key man Insurance policy;
- for a policy issued between April 1, 2003 and March 31, 2012 the premium paid in a year had to be less than 20% of capital sum assured;
- for any policy issued on or after April 1, 2012 the premium paid in a year had to be less than 10% of the capital sum assured.
How they will be taxed going forward
Until 2021, ULIPs too enjoyed the benefit of tax-free payouts as long as they met the above criteria. After this though, the tax exemption for payouts from ULIPs was available only if the amount of premium payable in any year was Rs.2,50,000 or lower. (Read about how ULIPs and other insurance products are taxed in our article, ‘How is your insurance policy taxed?‘)
And now Budget 2023 has done the same thing to all other life insurance policies as well.
Three new provisions were added to section 10(10D). These effectively say that for life insurance policies issued on or after April 1, 2023 that meet the criteria above, payouts (of any nature including bonus) will be tax free only if the premium payable in any year does not exceed Rs. 5 lakhs. In case there is more than one policy, then this limit would apply to the aggregate of the premium payable in any year.
As a result, payouts received under a life insurance policy in excess of aggregate premium paid over the term of the policy and not claimed as deduction will now be taxable under the head ‘Income from other sources’.
Exceptions
There are some exceptions to this:
- Firstly, none of this would apply to policies issued before April 1, 2023.
- Secondly, none of this would apply if the payout is made on the death of the insured.
- Finally, none of these limits apply to a pure term life insurance policy where the only payout is made if the insured dies.
- An additional point to note is that in deciding the eligibility of a policy for exemption, one must consider the premium amount, exclusive of GST.
Key takeaways from the CBDT guideline
The CBDT guideline has illustrated the implementation of the above through 13 examples. All of the examples illustrate the application of the new provisions, assuming that the criteria of Section 10(10D), explained above, are met. While most of the illustrations are straightforward, the key takeaways are as follows:
One, the issue date of the policy is the key. For policies issued prior to April 1, 2023, nothing changes. Even if the annual premium is over Rs. 5 lakhs in any year, the payout is exempt from tax at all times.
For policies issued after April 1, 2023, as long as the annual premium is under Rs 5 lakhs throughout the premium paying term, the payout is tax exempt.
Two, if you have multiple policies, you need to look at the aggregate annual premium to ensure that it does not exceed Rs. 5 lakhs in any year during the premium paying term. If it does, you are allowed to pick the policies where the aggregate premium stays under Rs. 5 lakhs and get a tax free payout on these and pay taxes on the payouts of the others. See the example below. Applying this option to pick policies which can be tax exempt means that you could pick policies A and B to qualify for tax exemption on payout. In other words, you are allowed to choose the combination that is most beneficial to you to claim exemption.
Therefore, if you are planning to go for multiple policies, bear in mind this ‘aggregate’ rule before committing to a fresh policy. If, for example, the premium in Policy B were to be Rs 450,000 you would be able to use either Policy A or B for exemptions on income tax. Here, you can choose policy B as the payout is larger.
Remember the key point here that the ‘aggregate premium’ limit is applied for each year of the policy paying term. So if you have multiple policies with no overlap in premium paying terms, you may have a way out. Take a look at this example.
In this example, payouts under both policies X and A are exempt since the aggregate annual premium payment in any year did not exceed the limit of Rs. 5 lakhs.
Three, another important point to note is with respect to policies that the guideline calls ‘old eligible life insurance policies’. These are policies,
- Which are eligible, meaning they are issued on or after April 1, 2023 and
- Where consideration has been received under such policy in a preceding previous year (other than the current previous year for which taxability is being examined) and
- the above consideration has been claimed as exempt under 10(10D)
To put it more directly, an ‘old eligible policy’ is one where you have bought the policy after April 1st 2023, received a payout from it, and claimed this as tax exempt. You may no longer be holding this policy or paying the premiums on it. But the tax laws don’t let you forget this!
When you have an ‘old eligible policy’, this has to necessarily be included in seeing if other policies can be exempt too. You have to take the aggregate of the premium on eligible policies plus the old eligible policies to ensure they do not exceed the Rs. 5 lakh limit.
If the aggregate exceeds Rs. 5 lakhs, you can claim exemption only under those policies where the premium together with that of old eligible policies does not exceed Rs. 5 lakhs in any year in the premium paying term. Here is how it would work:
For the previous year 2033-34 (assessment year 2034-35, the year in which you file the returns), you would have claimed the payout of Rs. 50 lakhs under policy X as exempt. Now, you may think that since X is no longer in force, you can claim exemptions on the payouts under policies A and B in the year 2034-35, since the aggregate premiums are less than Rs 5 lakh. Not so!
When we come to previous year 2034-35, you cannot claim exemption for any of the policies A, B or C. This is because policy X was an ‘old eligible life insurance policy’ which must also be taken into consideration. When you do that, the aggregate premium during the tenure of the policies, even if you just consider policy A with the lowest annual premium, exceeds Rs. 5 lakhs.
If, however, you had not claimed exemption for the payout under policy X, it would not be classified as ‘old eligible life insurance policy’ and therefore make payout under policies A and B tax exempt.
How to make it work for you
- Stick to pure term plans for your insurance needs. Check out ‘Prime Term Insurance’, our ranking of pure term plans and our ‘DIY Term Insurance Selection Tool’ if you are in the market for a term plan.
- If you still have a soft spot for the endowment plan, savings plan or other life insurance products and want it in your portfolio, keep the premium (aggregate) under Rs. 5 lakhs.
- If you are going for multiple policies where annual premium will exceed the limit, ensure there is no overlap in the premium paying term. This will keep your annual premium in any year under Rs. 5 lakhs.
- If all of the above are not possible, plan carefully as to which policy (policies) you will want to reserve for tax exemption and which ones you will pay tax on so that it is most beneficial to you financially.
- If you also hold ULIPS, the exemption for ULIPs and exemption for life insurance policies are calculated separately - i.e. they are two separate buckets.
