The tax-saving season is in full swing. Insurance companies have gone on an overdrive and have been advertising big time. The pitch of most of these advertisements is based on buying insurance for tax planning. But before you fall for buying an insurance policy to save tax, there are a few things you should know.
You may not get full tax deduction on the premium paid
We typically tend to assume that the entire premium paid for an insurance policy can be claimed as a tax deduction up to Rs 1 lakh. While that is true in most cases, it is not always so. And this is something that insurance companies will either not tell you or bury it in the details.
Take the case of single premium unit-linked insurance plans (Ulips), which are a fairly popular mode of investing to save tax. As the name suggests, the individual taking the policy needs to pay just one premium. The majority of the premium — after deducting for the premium allocation charge used to pay commission to agents — is invested. The portion invested is referred to as an investment fund.
The policy also provides a certain amount of life insurance cover, referred to as the sum assured. The minimum sum assured on a single premium Ulip has to be 1.10 times the single premium. Now, take an individual who pays a premium of Rs40,000 and opts for the minimum sum assured of Rs44,000 (110% of the single premium amount of Rs40,000).
Can he claim the entire Rs 40,000 as deduction? No. Sub-section 3 of Section 80C of the Income-Tax Act, states that a deduction is available only to so much of the premium, which is not in excess of 20% of the sum assured on the policy.
Simplified, in the above example, the single premium of Rs40,000 works out to around 91% of the sum assured of Rs44,000. But the allowable tax deduction is a maximum of 20% of the sum assured, which works out to Rs8,800. This is the amount on which a deduction can be claimed.
Thus, the individual cannot claim deduction on Rs31,200 of the premium. If the individual is in the 30% tax bracket, the tax on this amount would be Rs9,360 (30% of Rs 31,200).
The insurance company, of course, will not tell you this. A typical line in the brochure of a single premium policy reads like this: “Contributions made towards the premiums will be eligible for tax deduction under Section 80C of the Income-Tax Act”. This is correct in letter, not in spirit.
Individuals looking at single premium policies as a tax-saving investment should therefore, opt for a sum assured at least 5 times the premium paid. The individual in our example should thus opt for a sum assured of Rs 2 lakh to be able to avail a deduction on the full premium amount.
Your amount at maturity may not be tax-free
Another premise on which insurance is sold is that the entire amount at maturity is tax free. This, again, is not always the case.
Those opting for the minimum sum assured of 1.1 times must note that the entire maturity amount is not tax free. This is because, as per Section 10 (10D(c)) of the I-T Act, the entire amount is tax free only if the premium paid is not more than 20% of the sum assured, in any year of the policy. Otherwise, the entire amount at maturity gets lumped with the income for that particular year and gets taxed accordingly.
Most insurance companies do not reveal this in their sales brochures or at the time of selling the policy. In fact, it might be pertinent to ask how many insurance agents even know that such a provision exists.
This is true even in case of pension plans, which are another popular way of saving on tax. A pension plan is essentially a deferred annuity, in which the individual taking the policy needs to pay a regular premium. This premium is invested for a certain number of years. This phase is known as the accumulation phase. Hence, deferred annuities are like any other investment product which let you invest and accumulate a certain corpus of money, depending on the returns they provide. So, the name “pension plan” in this case is a misnomer.
Once the accumulation phase is over, at maturity, one-third of the corpus can be withdrawn tax free. The remaining has to be used to buy something known as an immediate annuity. An immediate annuity is a real pension plan, one in which the individual putting money is assured of a regular payment from the insurance company. This payment can be monthly, quarterly, once in six months or once a year, depending upon how the individual wants it to be structured. Immediate annuity assures that the policy holder gets a regular pension.
Those who want the entire corpus can surrender the policy. The problem here is that on surrendering the policy, the entire corpus will get added to the income for that year and be taxed at the prevailing tax rates. So the amount at maturity is not always tax free as it is made out to be.
Withdrawal before maturity can be taxable
Let us say the pension plan an individual buys is not performing well after a few years and he want to get out of it. The way the tax laws currently are, the individual will have to pay tax on the entire amount that the insurance company pays after deducting surrender charges. Again, this is something rarely declared upfront by insurance companies.
So the next time you buy insurance for tax planning, do remember that things are not always the way they are made out to be.
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