It will not be a surprise to note that you own one of the old age insurance policies such as Endowment, Money Back, ULIP, Whole life and Pension Plans. You may have paid a regular premium or just paid a single premium at the time of purchase.
All of these insurance policies are investment based insurance products since they have an investment component along with a risk protection component or the insurance.
Unfortunately, several of these insurance policies were mis sold to unsuspecting buyers and they are now leaving their policy in between. They are either making them paid up or going for outright surrender, which invites taxation.
Let’s be clear that the amount received on death of the insured person is completely tax-free under Section 10 (10D). It is only in case of surrender that there is a taxation aspect – taxation of the surrender value of the receipts from the insurance policy.
Several individuals have regarded an investment-based insurance policy as a capital asset and hence, treat only the gains as taxable. Some have also gone as far to index the cost (the investment part of the premium paid) of the policy and hence calculate and pay taxes on this indexed gain.
In good common sense, this seems to be the fair thing to do. But unfortunately, as per the current tax laws, this treatment does not work with insurance policy payouts.
The IT Act of 1961 defines what is a capital asset and the exemptions applicable.
In my interpretation, an insurance policy is not a capital asset. The premium that you pay is for coverage of risk.
When you pay premium on an insurance policy, you have a guarantee to receive the sum assured or the embedded value in the policy, in an eventuality of death. This benefit can far exceed the value of the premiums you have paid.
Unlike an investment in mutual funds, fixed deposits or Postal Schemes, the insurance premium is not a capital contribution.
Due to this reason, the gains made on insurance policy are not to be treated as capital gains. Also, the capital gains rate (long term or short term) as also indexation is not available on insurance policies.
This understanding is important to ensure that you treat your payouts correctly from the point of view of taxation.
Along with the least sum assured (times of premium) as well as the date of buying the policy, the capital asset treatment will help you determine the correct tax that you need to pay on your surrender value of your policy.
Rest, buyer beware!
If you are faced with a similar dilemma with your insurance policy, you may want to download my premium eGUIDE on Surrender Value Taxation here. It contains details about various insurance polices, if taxable or not and how you should calculate your own tax (or no tax).