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Insurance: Full Tax on Surrender If Premium>10% of Sum Assured [Corrected]

Missed in the glory of the Budget 2012 are key changes in Life Insurance.

No 80C deduction if your Premium’s greater than 10% of the sum assured

Under Section 80C, you got an exemption for insurance premium paid, upto an overall limit of 100,000 per year. Earlier, insurance premium was only exempt if: the premium was less than 20% of “sum assured”.

New change: the premium needs to be less than 10% of sum assured for an 80C deduction.

Example: For a sum assured of Rs. 10 lakh, the maximum premium that you can pay to deduct under section is Rs. 1 lakh. Sum assured means the guaranteed sum that will be paid if you die.

This is prospective – that is, it applies only from 2012-13.

Bigger: Full Tax If You Surrender Such Policies Or If They Mature

If you surrender such policies (where premium>10% of sum assured), anytime after April 1, 2012, the amount you receive from that policy will be charged tax as income. This is regardless of whether you bought your policy years ago.

CORRECTION: I posted too early. The rule says:

[Add to income] any sum received under an insurance policy issued on or after the 1st day of April, 2012 in respect of which the premium payable for any of the years during the term of the policy exceeds ten per cent. of the actual capital sum assured:”;

I didn’t read the “Issued” part. so I assumed it was for all money received after 1 April 2012. That’s wrong, apologies!

Earlier, the limit was a premium of 20% of the sum assured. The change is to section 10(D), which exempts any income (including bonus) that you get from such policies. You could surrender policies anytime you wanted and the money you got was exempt from tax under section 10(D).

Now, with no such exemption for certain types of policies, geting money on maturity or even surrendering them early means you will be subject to tax on whatever you receive. (This only applies for the [Prem>10% of SA] policies that you buy after April 1, 2012)

(You cannot subtract the amount you paid as premium earlier as your investment – insurance payouts are not classified under capital gains, therefore the concepts of “indexation” and “cost of acquisition” will not apply)

“Actual” Sum Assured

To avoid insurers that randomly raise or drop the sum assured to meet such tax limits, the new rules apply to the lowest sum assured in the term of the policy. So if you have a decreasing sum assured, you had better be paying premium less than 10% of the LOWEST sum assured ever. This is now defined as the “Actual sum assured” in the IT Act. (I’ll just call it sum assured in this post)

What if you’re paying more than 10% of SA?

If you took a policy or earlier that requires you to pay a higher premium than 10% of sum assured, you must note that you may not get an 80C deduction. Bad luck, but you didn’t buy insurance to save tax, but only to create a long term investment and did you? Oh, you did? Sorry.

But you must consider surrendering the policy NOW. If you try to surrender after April 1, 2012, whatever money you get will be added to your total income and you’ll be taxed on that.

Correction: I’ve scratched out the earlier advice – you no longer NEED to surrender such policies, and the money you receive from them (if bought before April 1, 2012) will be tax exempt under section 10D.

But why would you buy a policy with Premium > 10% of sum assured? To put things in perspective: if you invested 1 lakh per year for a policy with Rs. 5 lakh sum assured, three years later, you’ve paid Rs. 3 lakhs. Let’s say you surrender after April 1, 2012, and its surrender value is Rs. 3.5 lakhs. So, 3.5 lakhs is added to your income and voila, you’re going to pay upto Rs. 1.05 lakhs as tax (if you’re in the 30% bracket).

Your investment: Rs. 3 lakhs. Your return: Rs. 2.45 lakhs. The insurer will claim your return is positive, but after tax you lose money (You might only be marginally positive if you consider the taxes saved when getting in)

What About The Future? DTC says 5%

Well, the current edition of the Direct Tax Code reduced the limit further to 5% of the sum assured. If you’re paying more, you might get hit with this law next year. So, prepare adequately. (In all likelihood, you will be safe since old policies might be protected or “grandfathered”. But the tax department has a strange attraction to the word “retrospective”)

References: The Finance Bill and the Budget Memorandum (last two points).

Note: I get a lot of email asking for specific advise about what to do with a specific policy. If you would like such advice, please note that I charge Rs. 5,000 (plus service tax), payable in advance, as an advisory fee.

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