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Thursday, January 13, 2011

This year don’t buy insurance to save tax

Your life insurance plan will give you tax breaks this year but it might not be eligible for deduction after the proposed amendments in tax laws. Here is what you should consider when you buy a policy.

Almost 70% of all insurance policies is bought in the last three months of a financial year. This indicates that many of these plans have been bought with the sole purpose of saving tax. The majority of buyers don’t care what they are buying as long as it helps them save tax.

If you are such an investor, be careful when you buy an insurance policy. Your investment will give you tax breaks this year but may not be eligible for any deduction in the coming years. The proposed Direct Taxes Code (DTC), which comes into effect from 1 April 2012, has laid down very stiff conditions for the deduction of the premium from the taxable income and the exemption for income from insurance policies.

One of the key insurance-related provisions of the DTC is that a policy will not be eligible for tax deduction if it offers a life cover of less than 20 times the annual premium.

This means if the premium of an endowment insurance policy or a Ulip is Rs 20,000, it should offer a life cover of at least Rs 4 lakh to be eligible for tax deduction in the coming years. If this condition is not met, not only will the premium lose tax benefits but even the income accruing from the policy will be taxable.

It has been often said that life insurance should be used as a wealth protector, not a wealth creator. One should have a cover big enough to settle all outstanding loans as well as create a corpus of 8-10 times the annual income. If a person’s gross annual income is Rs 6 lakh, he should have a cover of at least Rs 48-60 lakh. However, the average insurance cover per policy in India is less than Rs 1 lakh.

But instead of term insurance plans that provide a large cover at low cost, Ulips and endowment plans are more popular with investors. The bigger loss is that the risk cover these policies offer is so low compared to what an individual needs that it is almost meaningless. What’s more, since the premium of traditional insurance plans is very high, a policyholder is not in a position to buy more life cover for himself.

A term plan for a risk cover of Rs 50 lakh would cost a 25-year-old man less than Rs 6,000 a year. A simlar cover from a Ulip or an endowment plan would come for at least Rs 2-3 lakh.


This may have to change after the DTC kicks in. A major game changer for life insurance is that the tax deduction limit will get reduced from the present Rs 1 lakh a year to only Rs 50,000 a year under the DTC. That’s not all.

This Rs 50,000 limit would also include the amount paid for tuition fees of children as well as medical insurance. Hence, there won’t be too much head room left for a big premium paid on an insurance policy.

There are other things to keep in mind too. Insurance agents like to lure buyers by saying they can withdraw from their Ulips after a few years. This lock-in period used to be three years but the Insurance Regulatory and Development Authority has extended it to five years.

Nonetheless, it is a widely used ploy to sell Ulips because partial withdrawals are tax-free. Right now, any income from insurance is tax-free except the premature surrender of a pension plan or a Ulip before five years. But under the DTC, withdrawals from Ulips will attract capital gains tax on the basis of the holding tenure.

If you still want to buy an insurance policy to save tax, make sure that the life cover it offers is big enough. This would be possible if you take long-term plans (at least 20 years). Your agent might try to dissuade you from opting for a higher risk cover in your Ulip. He would point out that a higher deduction for mortality charges would reduce the funds available for investment. Don’t let that make you opt for a plan that might lose all tax benefits two years from now. 
For investors who are comfortable taking risks, equity-linked saving schemes are a better way to save tax. These funds have given high returns in recent years and have a lock-in of only three years, which is the shortest for any Section 80C option. But being equity-oriented funds, they are subject to market risks and one should enter only if he can stomach the ups and downs.

For those with a lower risk appetite, the New Pension Scheme (NPS) is a great way to save tax. NPS investors have the choice of investing in funds managed by six mutual fund houses.

The NPS allows up to 50% equity exposure and the charges are negligible compared to the terribly high costs of investing in a Ulip or a unit-linked pension plan from an insurance company. But NPS is not as liquid as ELSS funds and investments that get tax deduction cannot be withdrawn before retirement.
By Sudhir Kaushik, Co-founder & CFO, 

1 comment:

Manjunath said...

I did not new about the new tax laws .. thanks for sharing such a useful information . :)