Many people buy life insurance policies just to save on taxes. But that is not advisable as the real purpose of life insurance is to secure your dependents financially.

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The tax benefits, which are often the most-discussed aspect of insurance policies, are actually a positive side to those products and not the main benefit. And since an insurance policy is an important aspect of our financial lives (and those of our dependents), it is important to understand all the aspects of it. So, you shouldn’t focus only on tax benefits available under Section 80C, but also on how maturity amount is taxed later under Section 10(10D).

But why worry now when insurance maturity is still years if not decades away?

Because the ratio of the premium you pay and sum assured you get is used to determine whether your maturity amount will be tax-free or fully taxed.

Many people aren’t aware of this and their agents may not have informed them properly.

Taxing maturity proceeds

Taxation aspects of life insurance occur in both phases:

- During the premium payment years

- On policy maturity

The premium paid to the insurance company can be claimed as a deduction.

But is the entire premium amount you pay tax-deductible? The answer is no. Only the premium that doesn’t exceed 10 per cent of the sum assured (for policies issued after April 1, 2012) is tax-deductible.

For example, say, you buy a policy with Rs 10 lakh sum assured and annual premium Rs 1.25 lakh. Now, the premium paid (i.e., Rs 1.25 lakh) exceeds the 10 per cent limit of sum assured (Rs 1 lakh = 10 per cent of Rs 10 lakh). So, you will only get a tax deduction on Rs 1 lakh and not on the full Rs 1.25 lac premium. Any premium above the 10 per cent limit does not qualify for tax deduction under section 80C of the Income Tax Act.

For policies issued before April 1, 2012, the 10 per cent rule changes to 20 per cent.

Also, this 10 per cent rule is separately capped by Section 80C’s Rs 1.5 lakh limit.

Sum assured and premium threshold

Now, most people ignore the taxation of insurance policies on maturity as you will see shortly.

It’s a common perception that all maturity proceeds of all life insurance policies are tax-free. But is this perception correct?

No. And this aspect comes under Section 10 (10)D of the Income tax Act.

And here is what this section says.

If the premium paid exceeds 10 per cent of the sum assured of the policy, then the maturity proceeds would be taxable in the hands of the insured person (for policies purchased after April 1, 2012). And this 10 per cent rule changes to 20 per cent for the policies purchased before April 1, 2012.

So, the myth of all maturity benefits of life insurance policies being tax-free is busted.

Using the earlier example, if you bought a life cover with Rs 10 lakh sum assured and annual premium Rs 1.25 lakh, then the premium paid (i.e. Rs 1.25 lakh) exceeds the 10 per cent limit of sum assured (Rs 1 lakh = 10 per cent of Rs 10 lac). So, as the 10 per cent condition is not met, the entire maturity proceeds will be taxed as per the prevailing rates in the year of receipt.

It is worth highlighting that we are talking here about maturity proceeds. In case of death, the benefit received shall be tax-free in the hands of nominees (even if premiums in any year had breached the 10 per cent rule).

So, for all insurance policy buyers, it is of utmost importance to understand the 10 per cent rule regarding both Section 80C and Section 10(10D).

And it is in your best interest to ensure that the premium paid doesn’t breach the 10 per cent of sum assured rule.

-by Dev Ashish

(Source: Moneycontrol.com)