From April 1, 2023, the maturity proceeds from traditional plans (commonly known as endowment plans) with annual premium exceeding Rs 5 lacs will be taxable.
This is a big change. We have all grown up knowing that the maturity proceeds from life insurance plans were exempt from tax. There was a minor exception when the life cover was less than 10 times the annual premium. Apart from that, the maturity proceeds from all life insurance polices were exempt from tax.
That changed a few years when the Govt. started taxing high premium ULIPs. Now, the Govt. has broadened the scope and brought the traditional life insurance plans under the tax ambit too.
Wanted to quickly find out about the different kind of life insurance plans, check out this post.
How Traditional Life Insurance Plans will be taxed from April 1, 2023?
The maturity proceeds from the traditional plans (endowment plans) shall be taxable provided:
- The plan is bought on or after April 1, 2023. AND
- The annual premium exceeds Rs 5 lacs.
The income from such plans shall be treated as “Income from other sources”. And not as Capital gains.
You can reduce income by the amount of Premium paid provided you did not claim deduction for the premium paid under Section 80 C (or any other income tax provision).
Therefore, if you took the tax benefit for investment in the plan under Section 80C, you will not be able to reduce the premium paid from the maturity amount. However, as I understand, if you invest Rs 8 lacs per annum and take maximum benefit of Rs 1.5 lacs under Section 80C, you can still deduct Rs 6.5 lacs from the final maturity amount and save on taxes.
This threshold of Rs 5 lacs for traditional plans is different from the threshold of Rs 2.5 lacs for ULIPs.
So, you can invest Rs 4 lacs per year in a traditional plan and Rs 2 lacs per year in a ULIP. Since neither of the thresholds (Rs 5 lacs for traditional plans and Rs 2.5 lacs for ULIPs) is breached, you do not have to pay tax on either of these plans.
The threshold of Rs 5 lacs is an aggregate threshold
You can’t invest in 2 traditional plans with annual premium of Rs 3 lacs to get tax-free maturity proceeds.
Example 1: Let’s say you invest in 2 plans (Plan X and Plan Y) with an annual premium of Rs 3 lacs each. Now, annual premiums for both the plans are under the threshold of Rs 5 lacs. But on aggregate basis, they breach the threshold of Rs 5 lacs.
In this case, you can choose the policy whose maturity proceeds you want to accept as tax-free. My assessment is based on the clarification the Income Tax Department gave in the case of taxation of ULIPs.
If you choose X, the maturity proceeds from Plan X will become tax-exempt, but the maturity proceeds from Plan Y will become taxable. Both can’t be tax-free (since their premium payments coincided in at least one of the years and the threshold of Rs 5 lacs was breached).
For the proceeds to be tax-free, this condition must be met every year.
Example 2: You buy a new plan (Plan A) in April 2023 with an annual premium of Rs 3 lacs for the next 10 years. The policy in FY2034.
In April 2032, you buy another plan with annual premium of Rs 4 lacs. Policy term of 10 years.
In FY2033, you pay a premium of Rs 7 lacs (Rs 3 lacs + 4 lacs) towards traditional plans. There is overlap of just 1 year in these plans.
Since this threshold of Rs 5 lacs was breached in FY2033 on aggregate basis (but not individually), the maturity proceeds from only one of the plan will be exempt from tax. And you can choose which one. Either Plan A or Plan B. Not both. You can pick one where you are likely to earn better returns.
Why has the Government done this?
The tax incentives were offered to taxpayers to encourage savings and to subsidize the cost of life insurance. But not unlimited savings. Therefore, if you look at the tax benefits on investment, those were capped at Rs 1.5 lacs per financial year under Section 80C.
Not just that, the income from some of these investments was made tax-free. However, the Government thinks that these incentives have been misused to earn tax-free returns. Clearly, small investors can’t abuse the system beyond a point. It is the bigger investors (HNIs) that the Government seems wary of.
Here is an excerpt from Budget memo.
By the way, not all Section 80C investments enjoy tax-free returns. Think of ELSS, SCSS, NSC, and now even EPF and ULIPs. Thus, taxing traditional plans is a logical step forward.
PPF is the last bastion but that’s too politically sensitive. In addition, the investments in PPF were always capped. Thus, it could never be misused to the extent other products were.
The Consistency
Let’s look at how the Government has brought various investment products into the tax net.
Equity Mutual Funds and stocks: Brought under the tax net in Budget 2018
Unit Linked Insurance Plans (ULIPs): High premium ULIPs brought under the tax net in Budget 2021.
EPF Contribution: Employer contribution brought under the tax net in Budget 2020. Employee contribution (exceeding Rs 2.5 lacs) in Budget 2021.
It is only logical that high premium traditional plans also started getting taxed.
The threshold of Rs 5 lacs also ensures that smaller investors are not affected. And this is also consistent with how other products have been brought under the tax net.
With equity funds and stocks, LTCG up to Rs 1 lac is exempt from tax. Useful for small investors. Meaningless for big portfolios.
Capital gains from ULIPs with annual premiums up to Rs 2.5 lacs are still exempt from tax.
EPF contribution up to Rs 2.5 lacs is still exempt from tax.
What remains unchanged?
The death benefit from any life insurance plan (term, ULIP, or traditional) remains exempt from tax irrespective of the annual premium paid. Only the maturity proceeds from traditional plans (with annual premiums over Rs 5 lacs and bought after March 31, 2023) are taxable.
The maturity proceeds from traditional plans bought up to March 31, 2023, remain exempt from tax irrespective of the premium paid. Therefore, if you have paid the first premium on or before March 31, 2023, your policy is safe from taxes. Note you may pay premium for such plans (bought on or before March 31, 2023) in the coming years but such premium won’t count towards the threshold of Rs 5 lacs.
Thus, you can except massive push from the insurance industry to sell high premium traditional plans before March 31, 2023. A bit surprised that the Government gave the cushion of 2 months. ULIPs and equity investments did not get such a cushion. The rule was effective February 1.
Annuity plans or pension plans (LIC Jeevan Akshay and LIC New Jeevan Shanti) are not affected. The income from such plans was anyways taxable.
What do I think?
It is a brilliant move.
There is no reason why traditional life insurance plans should continue to enjoy special tax treatment when all other investment products are getting taxed.
While taxation of investment product is an important variable in the decision process, it can’t be the only one. You must choose investment products that will help you reach your financial goals. Based on your risk appetite and financial goals.
What are the problems with traditional plans?
High cost and exit penalties. Low flexibility. Poor returns.
You may be ok with all that. However, most investors do not understand the product and implications of high exit penalties. They trust the salesperson to take care of their interests. However, front loaded commissions attached to the sale of such plans can put investor interest on the backseat. The front loading of incentives also makes these products ripe for mis-selling. By the way, front-loaded commissions are also the reason for high exit penalties.
Since IRDA, the insurance regulator, does not care about looking into this obvious issue, it is good that the Government has attacked these plans, albeit with a very different motive.
This tweet from Ms. Monika Halan, an author and Chairperson IPEF SEBI, aptly captures the issue.
My only complaint is that the Government could have kept this threshold lower. ULIPs have a threshold of Rs 2.5 lacs. A lower threshold would have forced even smaller investors to think deeper before investing in such plans. After all, it is the small investor who is affected the most by such poor investment decisions.
Featured Image Credit: Unsplash
