There is no provision for taxability of the entire surrender proceeds even if you claim the premium amount as a deduction for tax purposes
Brijesh called me with a query on a pension plan. Many years back he had (mis)sold a pension plan with an annual premium of Rs 5 lakh which he had faithfully paid for five years but had since stopped paying. The fund value was around Rs 32 lakh and he wanted to redeem the money. The insurance company had told him that the entire surrender value of Rs 32 lakh would be treated as his income and he would have to pay tax on the full amount.
Brijesh was annoyed about the entire affair. He had assumed that the proceeds were tax free simply because he was dealing with a life insurance company and in his understanding all policies issued by insurance companies were tax free. It was only now that he realised that “pension policies” issued by life insurance companies were taxable. Even then he was incredulous that he would be taxed on the entire amount redeemed though he had never claimed any tax benefits in respect of this contribution and the returns has also been so poor.
Brijesh told me that if the entire amount of Rs. 32 lakh were liable for taxation, the tax payable would far exceed the meagre returns of Rs 7 lakh that he had managed to get on this investment.
I asked Brijesh not to get worked up. The insurance company was only trying to scare him into retaining the money in the pension plan as it was in its (the nsurance company’s) interest to do so. The insurance company’s claim that the entire redemption proceeds are taxable, is only partially true. If he had claimed any tax benefits in respect to the premium paid by him on the pension plan then what the Insurance company was saying was true. Since Brijesh mentioned that he had not even mentioned this premium in his income-tax return, there was no question of taxability of the entire amount redeemed.
I informed Brijesh that unfortunately, it was not very clear whether the income on redemption (Rs 7 lakh) would be taxed as capital gains or as income from other sources. In my opinion, he has a fair chance to treat the income as income from long-term capital gains and take the benefit of the concessional tax rate of 20% after considering indexed cost. Off course, there are practical difficulties on how indexed cost would be calculated in this case. A conservative approach would be to pay tax on the difference of Rs 7 lakh as if it was income from other sources.
Brijesh was more reassured after this chat and asked me what would have been my opinion had he claimed a tax deduction on part of the premium paid by him. That is indeed a million-dollar question, I told him for which I had no answer. The tax department should clarify the tax treatment for such cases.
A very similar issue had arisen in the case of another client Pritesh who had bought a life insurance policy for a sum assured of Rs 90,000 where the annual premium was Rs 30,000. He had paid the premium for five years. He recently surrendered the life insurance policy and received Rs 1,53,000 (or just Rs 3,000 more than the premium he had paid).
The life insurance company had deducted tax at source on the redemption proceeds which is when he realised that the surrender value is taxable. Pritesh had approached me for advice on the taxability of the surrender proceeds. Unlike a pension policy there is no provision for taxability of the entire surrender proceeds even if Pritesh had claimed the premium amount as a deduction (to the extent allowed) for tax purposes. The proceeds were not exempt from tax either as the premium was more than 10% of the sum assured. Therefore the income portion of the proceeds would be taxable.
In Pritesh’s case, the net income was only Rs 3,000 over and above the premium paid by him. Would he pay tax only on that amount as income from other sources? Or again, will it be taxed as capital gains, and, because of indexation of cost, would he actually be able to claim a long-term capital loss?
I advised Pritesh that he would be better off showing Rs 3,000 as income from other sources and paying tax accordingly. Again, it would help if the tax department clarifies the tax issues surrounding such “investment” oriented life insurance policies.
If you have claimed a tax deduction in respect to the premium paid on pension policies, the entire redemption proceeds would be taxable. If you have not claimed any such tax deduction you will be liable to pay the tax only on the difference amount between premium paid and redemption proceeds received. For life insurance policies, whose redemption proceeds are not exempt because their premiums are higher than 10% of the sum assured, again the difference between the redemption proceeds and the premiums paid will be taxable probably as income from other sources.
THE ART OF TAX-SAVING
- There is no provision for taxability of the entire surrender proceeds even if you claim the premium amount as a deduction for tax purposes
- If you have claimed a tax deduction in respect to the premium paid on pension policies, the entire redemption proceeds would be taxable
- For life insurance policies, difference between the redemption proceeds and the premiums paid will be taxable
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