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Life Insurance and Taxation

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Indians purchase life cover not just to minimize the financial implications of sudden death or disability but also to increase their long Term savings. The Government has encouraged the life insurance as a savings option by offering tax benefits and rebates for those who pay their insurance premiums in a prompt manner.

However, the Direct Tax Code seeks to bring about a change in the taxation policies applicable to life insurance policies. The Code seeks to differentiate between traditional Risk minimizing policies and modern wealth building life cover.

Currently, Section 80C of the Income Tax Act, 1961 provides a taxable income deduction of up to Rs. 1 lac on the taxable income of the assessee provided the same is paid to life insurance companies as Premium on policies held in the name of self, spouse or kids. The premium paid on policies held in the name of family members can be deducted from the taxable income only if the assessee is the Karta of a Hindu Undivided Family.

Simply put, an assessee who has taxable income of Rs. 4 lacs and has paid Rs. 1 lac towards life insurance premium can Claim deduction u/s 80C and will be required to pay tax on Rs. 3 lacs (Rs. 4 lacs less Rs. 1 lac) only. The deduction available u/s 80C on life insurance premium is Rs. 1 lac of the amount paid whichever is less.

In 2003, the government introduced a new amendment requiring the premium paid every year to be less than or equal to 20% of the value of the policy. This meant that a person paying Rs. 40,000 premium for a sum Assured of Rs. 1.5 lac would be eligible for deduction of Rs. 30,000 (20% of Rs. 1.5 lacs) for the year. This amendment was applied prospectively to policies issued after 31.3.2003. This meant that only those persons using life insurance for risk management would enjoy all the tax benefits. Those opting for profit based life insurance policies like ULIPs would be subject to a restricted taxation policy.

The 2012-13 budget has reduced the 20% limit to 10%. This means that a person paying Rs. 10,000 as life insurance premium will be eligible for deduction of the entire amount under Section 80C, only if the Sum Assured was Rs. 1 lac or more.

The DTC provisions seek to reduce this figure further to 5%. This means that the sum assured must be 20 times the premium paid for the same to be completely eligible for tax benefits. If this limit is exceeded, the sum received by the Policyholder after Maturity of such a life insurance Policy will be completely taxable.

As on date, the government follows an Exempt-Exempt-Exempt policy as far as life insurance policies are concerned:

1st Exempt-

The premium paid towards the policy is exempt from tax.

2nd Exempt-

The increase in value of the policy until maturity is not taxed in the hands of the policy holder.

3rd Exempt-

The sum received at the maturity of the policy is also exempt.

After the DTC is introduced, the government will follow an Exempt-Exempt Tax policy on those insurance policies where the sum assured is less than 20 times the annual premium paid.

As on date, the maturity sum received is tax free. Under Sec 10 (10D) of the Income Tax Act, the exemption covers any Bonus or other additional payments made by the insurance company over and above the sum assured up to the maximum limit of Rs 10,000, additional Rs 5000 for senior citizen.

After the DTC is introduced, the maturity sum will enjoy tax benefits only if one of the two conditions is fulfilled:

The sum assured is at least 20 times the annual premium paid, or

The maturity sum is received upon the death of the policy holder.

It can be safely said that the government seeks to tweak its taxation policy and wants tax benefits to accrue to those life insurance policies that focus on risk minimization. Those life insurance policies that focus on wealth building shall be eligible for reduced tax benefits.