InvestorQ : How to use life insurance policy as a method of covering risk and also as a means of tax saving? Do they conflict each other?
Ria Jain made post

How to use life insurance policy as a method of covering risk and also as a means of tax saving? Do they conflict each other?

Anu Biswas answered.
2 years ago

Actually they do not need to conflict one another. It is said that your tax planning and your financial planning should typically begin with insurance as it covers your risk and ensures that other goals in your financial plan are not negatively impacted. That is why your financial planning process typically begins with ensuring that all your risks are adequately identified and insured.

Apart from playing the role of a risk-mitigation tool, insurance is also a very important tax saving tool. Of course, most financial advisors will tell you not to mix your insurance planning and tax planning. That is correct. But it is very instructive for you to understand the nuances of taxation of insurance. It is not just about the tax benefit under Section 80C that you are all familiar with. It is actually a lot more...

How the lure of life insurance is influenced by Section 80C of the Income Tax Act

Section 80C offers you an exemption of Rs.150,000/- per annum. Insurance premium is one of the components of Section 80C. Apart from insurance premiums paid, you have other deductions like provident fund contribution, tuition fees paid for your children’s education, long term fixed deposits, principal component of your housing loan repayment etc. The exemption of Rs.150,000/- is a composite ceiling including all these items. The advantage of the Section 80C exemption is that it is a direct deduction from your total income. For example, if your net income for the year is Rs.10,00,000/- and you have paid Rs.150,000/- as insurance premium for the year, then the entire premium of Rs.150,000/- is deductible under Section 80C.

Therefore, your taxable income stands reduced to Rs.850,000/-. Assuming that you are in the 30% tax bracket, this translates into an effective tax rebate of Rs.45,000 (for simplicity we have ignored surcharge in our calculations). That means you effectively paid a premium of just Rs.105,000/- during the year as Rs.45,000/- has come back to you in the form of tax exemptions. Remember, insurance premiums are only eligible for tax exemption under Section 80C if the premiums are paid on your life, your spouse’s life or on the life of your children. Premiums paid on the life of siblings and parents are not eligible for Section 80C benefits.

When you are paying insurance premium there is one thing you need to keep in mind. Your premium will be eligible under Section 80C only if your annual premium does not exceed 10% of the sum assured. The additional premium above 10% of your policy amount will not be eligible for tax exemption under Section 80C. That is something you need to keep in mind while planning your insurance needs.

Remember, the tax implications are not about premiums paid alone

Most people equate tax implications of insurance with Section 80C. There are a few more nuances that you need to keep in mind. The next question is whether the maturity proceeds of life insurance are taxable in your hands. If you are claiming death benefit from life insurance then that proceeds of the policy are entirely exempt. But what if your insurance policy matures under the normal course? You need to remember that if your insurance premium is more than 10% of the policy amount, then the insurance proceeds will be taxable in the year of maturity and will be added to your total income and taxed at your peak rate.

Of course, if your annual premium does not exceed 10% of policy amount then the insurance proceeds are entirely tax-free on maturity. Effective the last Union Budget 2014-15, the insurance company in question has been instructed to deduct TDS at 2% on the insurance proceeds if the said proceeds are taxable on maturity. This will ensure an audit trail for the tax authorities.

There is also an important implication when you surrender your life insurance

At times insurance policy holders tend to surrender their policy when they are in urgent requirement of funds for some exigency. Term policies do not have surrender value, but endowments do have surrender value. Insurance companies normally permit you to surrender your policy if you have paid premiums continuously for a period of 3 years or more. There is again a catch here. If you surrender your policy within a period of 5 years, then the entire proceeds will be taxable in your hands at your peak taxation rate. There is one more thing for you to remember. If you surrender your policy before a period of 5 years, then the tax exemption granted to you in the previous years will also be reversed. So you have to be extremely careful when you surrender your policy.

Life cover is different from the National Pension System (NPS)

There is a slight confusion in the minds of many people that the Section 80C limits were hiked to Rs.200,000 in the last budget. That is not correct. In fact a new Section 80CCD was introduced that offers an additional Rs.50,000/- exemption for contribution to the National Pension Scheme (NPS). The exemption under Section 80C continues to remain at Rs.150,000/- only. It is the sum total of Section 80C and Section 80CCD that totals to Rs.200,000/-.

Health insurance can be tax efficient too

Health insurance or medical insurance, as it is popularly called in India is a non-life insurance that covers you against hospitalization expenses. One needs to remember that Health Insurance is not just about hospitalization but also about home nursing, convalescing and even Ayurvedic treatment, as amended in the last Union Budget. Typically, most health insurance companies offer cashless facility across their approved hospital list which is a big boon in case of sudden hospitalization. Health insurance comes in the form of dedicated policies and floaters. In a dedicated policy, you can get individual health cover for each member of your family. In a floater, you decide upon a total umbrella health cover and that can be shared by members of the family who are part of this floater policy. Floater happens to be a more economical and efficient way to use health insurance.

Understanding the eligibility and tax benefits of buying health insurance

For claiming tax exemption under Section 80D of the Income Tax Act, you can buy health cover on behalf of your spouse, children and dependent parents. There are two distinct components of health insurance benefit for the proposer. There is the basic Section 80D exemption that is available for yourself, your spouse and your children. Then there is an additional exemption available under Section 80D in case of your parents who are senior citizens, above the age of 60. Remember that tax breaks on life insurance and on health insurance are covered by two different sections of the Income Tax Act. Understanding the difference and the inter relationship is the key.