How Life Insurance Premiums Are Taxed? What Are The Loopholes?

Before April 2023 an individual was allowed to pay any sum of money as a premium for a life insurance policy and enjoy tax exemption on the entire premium upon maturity. This was one of the major tax benefits for life insurance policyholders. The Budget 2023 had made income from insurance policies (other than ULIPs for which there are separate provisions) having premium or aggregate of premium above Rs 5 lakh in a year as taxable. Such income is exempt if it is received on the death of the insured person. This income shall be taxable under the head “income from other sources”. 

Says Tarun Garg, director, Deloitte India: “The Unit Linked Insurance Policies (‘ULIPs’) have a separate rule with a lower cap of Rs 1.50 lakh for tax deductions under Section 80C. ULIPs enjoy tax-exempt status on maturity under Section 10(10D), provided the premium does not exceed the limit of Rs 2.5 lakh per year. For ULIPs issued on or after 01 February 2021, if the annual premium exceeds Rs 2.5 lakh, the maturity proceeds are taxable as long-term capital gains (LTCG) at maturity taxed at 10 per cent. This rule aims to curb the misuse of ULIPs for tax-free income. The ULIPs purchased before 01 February 2021, are tax-free at maturity, regardless of the annual premium amount. The death benefits from ULIPs are tax-free.”

Section 10(10D) provides for exemption concerning any sum received under other life insurance policies, including the sum allocated by way of bonus on such policy. However, exemption under Section 10(10D) is not available in respect of excess premium policies issued on or after 01-04-2003 and high premium policies issued on or after 01-04-2023. Thus, any sum received under such policies is considered income and chargeable to tax under the head "Income from Other Sources.”

“The sum received under excess or high premium life insurance policies is chargeable to tax under the head 'other sources' as per Section 56(2)(xiii). The Central Board of Direct Taxes (CBDT) has notified Rule 11UACA prescribing manner to compute income in respect of sum received under excess or high premium life insurance policies,” says Rahul Singh, senior manager, Taxmann, tax and corporate advisor. 

Also read; Taking Loan Against Your Life Insurance Policy: All That You Should Know

Such computation shall be made in the following manner:

(a) Sum received from life insurance policies for the first time

If the assessee has received the sum from high-premium life insurance policies for the first time, then the income shall be calculated in the following manner:

(b) Sum received from life insurance policies for the second time and subsequently

If the sum received from life insurance policies isn't the sum received for the first time, then the income shall be calculated in the following manner:

The income from excess or high premium life insurance policies shall be taxable at normal tax rates as applicable in the case of an assessee.

Loopholes: There could be certain loopholes where taxpayers may find ways to mitigate/ defer some taxes on the same by way of tax planning:

Loophole 1: Tax Deferral

Under this strategy, a taxpayer may seek to receive the maturity amount of the policy upon completion of the policy term in installments over several years, instead of getting it as a lump sum. The benefit of this strategy would be that since only the amount exceeding the total premium paid is taxable, spreading out the payout would allow to receive the initial installments (up to the total premium amount) as tax-free plus the benefit of slab rate exemptions can also be availed.

Loophole 2: Taking Multiple Life Insurance Policies (Premium Splitting)

This involves buying multiple life insurance policies in a single year, with the total premium on all insurance policies not exceeding Rs 5 lakh. Say an individual buys three policies of premium Rs 2 lakh each (Rs 6 lakh premium per annum). Upon maturity of the said policies, the individual could choose the one policy with the lowest tax liability and offer to tax accordingly.