Tax Benefits of Life Insurance Policies : Life insurance policies have long been favored by their subscribers, primarily due to the tax advantages they offer. However, there was a significant shift last year, as the maturity proceeds of high-premium life insurance policies (where the premium exceeds 15 lakh annually) became taxable for all policies sold on or after 1 April 2023. These proceeds are now treated as income from other sources and taxed according to the policyholder’s slab rate. While this is widely known, less discussed is how to calculate the taxable proceeds in such plans. Will every penny of the maturity amount be taxable, or are there deductions? This is where things become intriguing.
Tax Benefits of Life Insurance Policies
The Central Board of Direct Taxes (CBDT) issued a notification in August 2023, introducing a new tax rule – Rule 11UACA – for computing the proceeds of life insurance plans under Section 56(2)(xiii) of the Income Tax Act, 1961. It provided 13 examples to illustrate this rule. However, these examples only considered the lump sum payout upon maturity and did not address scenarios where regular income or survival benefits are paid over multiple years.
Some experts in the insurance industry suggest that such plans are currently marketed on the premise that payouts will not be taxable unless the total premiums paid during the premium payment term are offset against them. To illustrate this, let’s consider the case of a non-linked, non-participating savings plan from a leading life insurance company, subscribed by a 54-year-old individual for a 25-year policy period.
In this case, the annual premium to be paid over a period of 10 years is 125 lakh, with payouts starting from the 11th year onwards. The payout is fixed at 131.34 lakh for 15 years. Should the annual payout of 31.34 lakh be taxable since the annual policy premium is more than 5 lakh? Yes, indeed! However, not all payouts will be taxable.
According to the CBDT notification, if the taxpayer receives the payout from such a life insurance policy for the first time, the taxable income shall be calculated as A-B, where A is the amount received, including any bonus allocated, and B is the aggregate of premiums paid during the term of the policy until the date of receiving such a sum, which has not been claimed as a deduction under any other provision of the IT Act.
Vice President of Research and Advisory at Taxmann, explains that the first payout will not be taxable as the aggregate premiums paid in previous years exceed the annual payout.
What about the second payout
The CBDT notification states that if the taxpayer receives (Tax Benefits of Life Insurance Policies) the sum under the life insurance policy for the second and subsequent times, the taxable income shall be C-D, where C is the amount received during the subsequent fiscal year, and D is the aggregate of premiums paid during the term of the policy until the date of receiving the sum in the subsequent fiscal year, not including premiums claimed as deductions under any other provision of the IT Act or included in previous years’ income calculations.
Between the first and seventh payouts starting from the 11th year, a total of 12.19 crore premiums will have been adjusted. In the 18th year, 30.61 lakh premium (12.5 crore minus 2.19 crore) will need to be adjusted against the 8th payout. Therefore, a sum of 173,024 (31.34 lakh – 30.61 lakh) will be taxed at the individual slab rate. Note that 31.34 lakh is the annual payout mentioned earlier. Payouts from the 19th year onwards will be fully taxable.
Gautam Nayak, a Chartered Accountant and Partner at CNK & Associates LLP, explains that in a life insurance policy, income is computed only for actual receipts exceeding the premium paid. Therefore, payouts by the insurer are first adjusted against premium payments, and no income arises until (Tax Benefits of Life Insurance Policies) premium payments are fully adjusted.
This interpretation suggests that the tax liability for insurance policies is deferred, unlike other financial instruments where capital gains are taxed in the same year they are accrued. Since these products are long-term in nature, the policyholder’s slab rate may change after retirement.
Regardless of the premium-payout combination, traditional life insurance plans tend to have a poor internal rate of return (IRR).
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