Life insurance has always been a popular investment avenue as the premium paid can be claimed as deduction from taxable income and the proceeds, including bonus, are also tax-exempt. However, there are a few important things to note when it comes to taxes.
Not all life insurance proceeds that you receive are tax-free, be it on maturity or surrender. Hence, to avoid unexpected income-tax consequences, it is important that you are familiar with rules on proceeds from insurance, whether on maturity or surrender.
Before the changes in law with effect from April 1, 2003, any proceeds received under an insurance policy (with some exceptions) were tax-free under Section 10(10D) of Income-Tax Act, 1961.
As per amendments introduced in the Finance Act, 2003, (i.e., with effect from April 1, 2003), any proceeds received on account of maturity/surrender of an insurance policy were exempt from tax only if the premium paid did not exceed 20% of the sum assured. As an example, if the annual premium is R10,000, to qualify for exemption, the minimum sum assured under the policy was required to be R50,000.
If the sum assured was less than the said value, the entire maturity proceeds would be taxable. Such limit of 20% was later reduced to 10% by the Finance Act, 2012, (i.e., with effect from April 1, 2012) to increase the insurance coverage amount, i.e., the sum assured threshold was increased from a minimum of five times of annual premium to 10 times. For policies taken on the life of a disabled person or person suffering from certain ailments, the limit was relaxed to 15% of the sum assured with effect from April 1, 2013.
The above change was introduced to curb the intentions of policyholders who purchased policies as an investment plan and where usually single premiums were paid for sums assured, which were less than 10 times the annual/single premium. Such a change helped shift the focus back from investment plans to life covers.
This change, however, did not affect holders of term plan policies, since the sum assured is several times the premium paid. This restriction is also not applicable to sums received on the death of the policyholder which continue to be tax-free.
Note that in case of individuals in the higher age group (above 50 years) where the risk is high, for a given amount of sum assured, the premium is also high, resulting in a situation where the premium is usually more than 10% of the sum assured. Hence, before they subscribe to insurance policies, such individuals should take cognizance of tax consequences that will arise on the maturity/surrender of the policies.
To have a mechanism for reporting and collecting tax on proceeds paid under a life insurance policy, which are not exempt under Section 10(10D), the Finance Act, 2014, introduced a new provision (with effect from October 1, 2014) wherein tax is required to be deducted at source by the insurance company before paying the taxable proceeds (interim or on maturity) to policyholders.
The insurer needs to deduct tax at source at 2% for proceeds of all taxable policies. However, to reduce the compliance burden on small taxpayers, no TDS is applicable for maturity value of less than R1,00,000. Since the income from insurance proceeds is taxed as per slab rates, the individual will have to discharge the balance tax on such proceeds by way of advance tax during the financial year.
Income from proceeds of an insurance policy is taxable under the head, income from other sources, for an individual. As the insurance company will deduct tax at source, it is essential for all policyholders to provide their PAN to the insurance company, failing which the insurer will be liable to deduct tax @ 20% of the life insurance proceeds. The tax deducted by the insurance company will reflect in Form 26AS of the policyholder as well as Form 16A provided by the insurance company, which can be used to claim a credit in the tax return.