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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, 

Why you should not pull out your FD

Banks have been raising interest rates on fixed deposits of various tenures by 0.5-0.75% in the past two weeks. A three-year FD in the second week of December 2010 was earning as much as 8.30-8.50%. The interest rate has since swelled to 9%. A senior citizen might even earn 10% by picking the right bank FD.

In this backdrop, it is tempting to withdraw an FD and deposit the money with a bank offering a higher interest rate. Here is why you should not rush.

Banks usually levy a penalty in the form of a 0.5-1% lower interest on customers looking to ditch their account for a rival’s.

"When the interest rate goes up in quick succession, people will start breaking existing deposits. Bank will feel the pressure," says S Govindan, general manager of personal banking and operations department at Union Bank of India. Banks are okay with customers reinvesting money with them, though there are exceptions.

HDFC Bank is one. The bank has said it will charge a 1% penalty on premature withdrawals for all fixed deposits, including sweep-in FDs (accounts that combine savings-current and fixed deposit features) and partial closures, from 24 January 2011.

Penal interest
ICICI Bank already charges a 0.5-1% lower interest rate to end an FD. The penal interest is 0.5% for a one-year deposit and 1% for deposits below `5 crore but with a higher tenure. A spokesperson of ICICI Bank said the penalty applies even if the money is re-invested.

Not every bank imposes a sweeping fine on withdrawals. IDBI Bank said last week it will not fine new or renewed FDs opened from January 1, 2011.

The penalty of 1% lower interest when people renew existing FDs or open a new deposit will now be waived off, says RK Bansal, executive director and chief financial officer of IDBI Bank.

If you break the FD now

It is a customer-friendly measure, says Bansal. People want to re-invest when rates rise, he says, though FD termination creates an asset-liability mismatch for the bank.

Like IDBI, public sector counterparts such as State Bank of India , Bank of Baroda , Punjab National Bank and Union Bank of India also impose a charge on premature withdrawal, even if it is partial. There is no fine on a deposit renewed for higher interest rate, said officials of these banks.

UBI’s Govindan says there was always a penalty on breaking an FD. UBI charges a lower interest rate of 1% on an FD removal. "But if you re-invest the same amount for a period higher than the remaining period of the original FD, the penalty is waived off," he says.

The waiver is paying off. "We are seeing people who were in for the shorter term are breaking existing FDs and going for the longer-tenure FDs because of the attractive interest rate," says Govindan.

The Reserve Bank of India had asked banks to allow conversion of fixed, recurring or daily deposits for reinvesting without reducing the interest as a penalty. In April 2010, RBI reversed its stance, saying banks can decide their own charges if people convert deposits to earn higher interest.

The leeway to banks means a rethink on pulling out money is in order. For a customer, it pays to calculate the penalty as some banks do not tell upfront about the charges while ending an FD prematurely. The accompanying tables will help you decide.

"Breaking an FD is helpful to a customer only if there is a rapid increase in interest for two weeks or one month as we have seen now," says Govindan. "If the rate moves up in the range of 300 bps (3%) in quick succession, you benefit."
This article first appeared in ET wealth 

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