Important facts about taxability of life insurance policy payouts

Mr. Raman had purchased a term insurance policy for a sum assured of Rs 1 crore with an annual premium of Rs. 12,000. He bought the plan based on a suggestion from his friend, hoping he would be able to save on the income tax at the end of every year on the premiums paid. Similarly, he also bought a ULIP plan for a sum assured of Rs.30 lakhs and an annual premium of Rs. 50,000. It was only later he came to know that the maximum deduction for premium paid should not exceed 10% of the sum assured on the policy. He had trusted his friend blindly without doing any research leading to the unnecessary purchase of two unrelated insurance policies, which ended up eating most of his investments.

Mr. Raman also had bought a money-back policy for Rs 10 lakh likewise, but again the maturity amount of Rs 10 lakh will be taxed in full under Section 10 (10D) since the annual premium for the policy was more than 10% of the sum assured, making Mr. Raman pay income taxes on the maturity proceeds as well, making all his insurance earnings go to waste.

Life insurance policy plays a very important role in any financial plan by helping you secure the future of your family members after your lifetime. With different types of insurance products such as ULIP and endowment policy available in the market to suit the needs and requirements of each person, an insurance policy is looked at as a long-term investment that helps build a solid foundation for a better financial future. In addition to financial security, the life insurance tax benefits are also aplenty, which is one reason many buy insurance policies. 

Types of Life Insurance policies

 Before we get into the life insurance taxability, let us look at the various types of life insurance policies that are available in India, as the method of taxation differs for each. 

• Term Insurance: The simplest form of life insurance is term life insurance. It provides financial security for your family in case of any unfortunate events such as death, accident, illness, etc.; In contrast, the death benefit is provided to the nominee on the death of the policyholder; there are no maturity or survival benefits provided to the policyholder if they survive the policy term. 
• Money-back policy: These policies offer the same features as that of a term plan, but the policyholder shall get back the premiums paid at the time of maturity. 
• Whole Life Insurance Policy: Very similar to a term insurance policy, but the tenure of whole life policies is higher than any other policies, providing coverage of up to 100 years of age.
• ULIPs: Unit Linked Insurance Policy combines the dual benefit of insurance and investment in a single plan. While one portion of the premium is invested in the market, the other portion is utilized to provide insurance coverage to the policyholder. At the time of maturity, the policy proceeds are paid back to the policyholder/ nominee along with the returns. 

Taxation of life insurance policy payouts

To encourage the purchase of insurance policies among the public, the government of India has made provisions in the law allowing for deductions for tax on life insurance premiums and exemptions on life insurance policy payouts. Individuals can utilize them while filing income tax returns every year at the time of receipt of maturity proceeds. The tax benefits on life insurance policies can be availed under the following sections of the income tax act:

• Section 80C
• Section 10 (10D)

Section 80C: For starters who might question whether life insurance premium is tax-deductible, the answer is yes. The premium paid toward any life insurance policy is eligible for tax deduction under Section 80C of the Income Tax Act, 1961, up to a maximum limit of ₹1.5 lakhs.

Section 10 (10D): Any amount that may be received as a death benefit or received as maturity proceeds at the time of survival, surrender, etc., is completely tax-free in the hands of a receiver, under section 10 (10D) of the Income-tax act 1961. 

Do you need to pay tax on surrender of life insurance policy? It simply means, no income tax needs to be paid on this amount subject to satisfying the following conditions:

• If an insurance policy is issued on or before April 1, 2012, the policy premium must not exceed more than 20% of the plan`s sum assured, for the maturity proceeds or death benefit received by the beneficiary from the insurer to be tax-free. If the insurance policy premium is higher than 20% of the sum assured, the benefit amount will be taxed. If the insured person dies during the policy tenure, then the death benefit paid to the nominee will not be taxed, even if the premium is more than 20% of the sum assured. 
• For policies issued on or after April 1, 2012, the entire proceeds are tax-free, only if the premium is up to 10% of the sum assured, or else the complete amount will attract income tax.

Similarly, if a policy is a Keyman insurance policy, the proceeds are not tax-free as per section 10(10D) of the Income Tax Act.

While buying a life insurance policy, most people look for income tax benefits on premium paid, maturity, or surrender benefits. But what has to be understood is, the purpose of buying a life insurance policy is more important than the tax benefits. 

At the same time, the maturity or proceeds amount received from the insurer also holds importance as you would not want to see a major chunk of the amount go out of your pocket as tax. To avoid this, you will need to pay attention to the taxability of life insurance policies as we all expect some sort of benefit for the amount paid.