Last week, we had discussed here how little life insurance policyholders are going to gain from the insurance regulators new norms on cost calculations in unit-linked plans (Ulips).

There is, however, a greater shock in store in the form of the exempt-exempt-tax (EET) regime.

The proposals of the new direct tax code pose severe tax threats to almost all life insurance plans, except term insurance.

Section 56(2)(f) of the code states that gross residuary income, which forms part of the total annual income for determining the tax liability, shall include any sum received under a life insurance policy, including the sum allocated by way of a bonus.

However, clause 4(c) of the section states that the assessee shall not be deemed to have received, or withdrawn, any amount in the financial year from any account maintained with any permitted savings intermediary if the amount is used for (i) purchasing an annuity plan; or (ii) rolling over the amount from one account with the permitted savings intermediary to any other account with the same or any other permitted savings intermediary.

Deduction list

The definition of permitted savings intermediary includes approved provident funds, approved superannuation funds, life insurers and the New Pension Trust.

According to clause (3) of Section 57, which provides for deductions from gross residuary income, any sum received under a life insurance policy, including the sum allocated by way of a bonus on such a policy, will be eligible for deduction if (i) the premium payable for any of the years during the term of the policy does not exceed 5 per cent of the actual capital sum assured; and (ii) the sum is received only upon completion of the original period of contract of the insurance or upon death of the insured.

In short, if your premium amount in any year is more than 5 per cent of the sum assured on the policy, you shall have to pay a tax on the maturity amount unless you use the proceeds to buy an annuity plan.

Under the current provisions of the Income Tax Act 1956, death or survival benefits of a life insurance plan is tax-exempt under Section 10(D). A tax deduction is available on premium payment only if the premium amount in any year is 20 per cent or less of the sum assured.

In almost all life insurance policies, except for term assurance plans, the annual premium amount varies between 10 per cent and 20 per cent, meaning that nearly all existing Ulips, money back, premium guaranteed, endowment and whole life plans will come under the tax net.

Tax on early withdrawals

Withdrawals of investments from a life insurance plan after three years were tax-exempt so far. But the new tax code proposes to tax any amount withdrawn before the maturity of the plan. And the tax rate will be determined after including the maturity amount in your total income.

An illustration

To illustrate the position, let us use the same example that we used last time. The age of the policyholder is 30 years and he pays an annual premium of Rs 50,000 for a sum assured of Rs 2.5 lakh unit-linked policy for a period of 20 years. If his fund value grows at an annual compounded rate of 10 per cent, the policy holder will get a minimum of Rs 23,54,134 under the new cost calculation norms of the insurance regulator.

Now, if the policyholders monthly income is anything above Rs 12,155, he will have to pay Rs 7,06,240 as income tax on the maturity amount of Rs 23,54,134! It is also to be noted that without the income from the insurance plan, the policyholder otherwise wont have to pay any tax (gross annual income is below Rs 1,60,000).

Smart choice

On the other hand, a 40-year-old person even today can buy a term assurance plan of Rs 5 lakh for an annual premium of Rs 3,700 for a term of 20 years. Since the annual premium here is much less than 5 per cent of the sum assured and there is no survival benefit from such a policy, there will be no tax liability.

The direct tax code will thus make people think of buying a life insurance plan as a pure risk cover rather than a tax-saving investment. This will also help policy buyers increase their life cover at a lower cost.

For growth of capital, people should look for proper investment avenues. Though the draft tax code proposes to remove the anomalies in capital gains tax (between short-term and long-term and among various investment assets) by taxing capital gains as regular income at normal tax rates, it proposes to extend the cost indexation benefits for all types of assets held for one year or more.

This benefit will accrue to all investment assets, including mutual funds and shares, but not to life insurance plans. In short, mutual fund investors will stand to gain in terms of tax outgo compared with Ulip holders.