In India, nearly two-thirds of all new life insurance policies are sold during the six months between September and March — an indicator that life insurance is bought primarily for tax saving. However, the New Direct Taxes Code, slated to be implemented from April 2011, proposes to do away with the disproportionate tax advantage that life insurance products have so far been enjoying over other savings instruments. The proposals of the direct tax code are still open for debate and discussions, but the underlying policy directions indicate that life insurance will be the most affected among all other investment instruments. This may affect your financial planning if you don't understand the implications and plan your insurance buying accordingly.
At present, premium payment for a life insurance policy is tax-exempt provided the premium amount is not more than 20 per cent of the sum assured. Similarly, any sum received under a life insurance policy — be it money back at regular intervals, death benefit, maturity benefits, including bonus and loyalty additions — is tax-free. But the new tax code envisages that any sum received under a life insurance policy, including death benefit, will be exempt from tax if and only if the premium paid for any of the years does not exceed 5 per cent of the sum assured. This provision, if it finds its way into the final bill, will prove the most significant because the premium installments of all life insurance policies, be it a traditional plan or a unit-liked one, as a percentage of sum assured is much higher than 5 per cent, except in the case of term assurance plans. In other words, benefits under all life insurance policies (except for term assurance) will become taxable from April 2011 unless insurers drastically reduce their premium rates to comply with the 5 per cent criteria. In other words, the sum assured of a policy should be at least 20 times of the annual premium — if you pay an annual premium of Rs 15,000 for a policy, the minimum sum assured should be Rs 3 lakh — to receive tax-free benefits from a life insurance policy. At present, insurance companies offer a minimum sum assured of only five times the annual premium — for an annual premium of Rs 15,000, you get a life cover of Rs 75,000.
Now, if life insurance products with their current features have to comply with the requirement for tax exemption under the direct tax code, the mortality charge payable by policyholders will increase four times (since the minimum sum assured will have to be increased four times). An increase of mortality charge will surely reduce the ultimate return to policyholders. Little wonder why life insurers lobbied and were successful in persuading the Insurance Regulatory and Development Authority (Irda) to exclude mortality charges when the regulator put a cap on various charges under unit-linked plans — the largest selling product in the life insurance space. Had the mortality charge been included in the overall cap on Ulip charges, insurers would not have any other way but to reduce the commission payable to agents in order to provide for higher sum assured to policyholders. Now that mortality charges are excluded from overall cap on Ulip charges, it is only the policyholder who will have to pay a higher cost and sacrifice return.
What we have discussed so far is only one aspect of the fallout of the new tax regime on life insurance. The New Direct Taxes Code has another bearing on life insurance policies. Under the new tax regime, premium payment up to Rs 3 lakh for a life insurance policy will be tax-exempt. But if the sum assured is not equal to or higher than 20 times the annual premium, any sum received under the policy will be taxed at the marginal rate applicable to the income bracket taking into account the benefits received.
For example, you have bought a policy having a sum assured of Rs 10 lakh and on maturity it amounted to Rs 30 lakh. Let us assume that your annual income at the time of the policy maturity is Rs 10 lakh. So, for income tax purposes, your total income would be considered as Rs 40 lakh (= Rs 10 lakh + Rs 30 lakh) and you shall have to pay income tax on the entire sum at the rate corresponding to the Rs 40-lakh income bracket. Let us now see what it actually means.
For this we consider two separate tax regimes — one is taxed-exempt-exempt and the other is exempt-exempt-taxed. Under taxed-exempt-exempt, you invest tax-paid income while the accumulation on the invested amount and its withdrawal are exempt from tax. Under exempt-exempt-taxed, your income is not taxed initially neither the accumulation on the invested amount. You pay tax on the withdrawal amount. .Till the rate of tax remains the same there is no financial difference whether it is TEE or EET regime. But if the tax rate is a progressive one, that is, the tax rate increases with the level of income, EET will yield much lower post-tax return than in TEE.Given the proposed tax slabs in the New Direct Taxes Code, you may have to pay a much higher tax on benefits received under a life insurance policy than a 10 per cent capital gains tax on investment in other instruments