When looking to invest in a viable financial instrument, one of the features that many investors look for is the tax-saving element. Ideally, an investment option should offer tax benefits along with good returns. Tax benefits are usually of two types – tax deductions and tax exemptions. Are you wondering if there are any financial products in the market that offer both types of tax benefits? Yes, a ULIP policy is one such product. It is a life insurance product that also has an investment element attached to it. One of the most important ULIP tax benefits is that, despite being considered an investment option, the returns from the ULIP plan are not taxed.
Yes, you heard that right. When you surrender the policy after a particular period, there is no income tax levied on the amount. We provide a detailed look at this below.
How does a ULIP policy work?
Before we proceed to the tax implications of ULIP surrender, let us first glance at how a ULIP works. When you pay the premium of your ULIP policy, the insurer distributes the money via two channels. They use one portion of the money to build your life insurance corpus amount and the other to invest in assets of your choice. The invested portion earns returns as per the market conditions. One can invest in equity funds, debt funds, and hybrid funds as per their risk appetite. To understand how the premium and the fund type affect the returns, you should use a ULIP plan calculator.
Now, let us see if, when, and how the taxation occurs on the ULIP surrender value.
Tax implications on ULIP surrender before 5 years
ULIPs have a lock-in period of five years. Within this period, the policyholder is not allowed to make any withdrawals on the plan. Similarly, if the policyholder surrenders the policy before the lock-in period ends, it is considered a source of income and thus, taxed as per prevalent income tax laws. Also note that regardless of when you surrender the policy in the first five years, you will receive the total amount after the end of the lock-in period.
Premature surrender also means that all the tax deductions that you may have previously claimed against the ULIP policy premiums (under Section 80C) will be reversed. They will be counted as a source of income and taxed accordingly.
Hence, it is best to avoid surrendering your ULIP before the lock-in period ends.
Tax implications on ULIP surrender after the lock-in period
When you surrender your ULIP after the end of the lock-in period, the amount received as the surrender value is not considered income and is not taxed as such. That is whyexperts suggest that if one wants to surrender their ULIP, they should do so only after the end of the lock-in period. However, like several other tax norms, this one of the ULIP tax benefits is also subject to certain complex conditions.
Usually, the surrender value of life insurance policies issued after 1st April 2012 is tax exempted if the annual premium of the policy does not exceed 10% of the sum assured. For policies issued after 1st April 2003 but before 31st March 2012, the premium limit is 20% of the sum assured.
For a ULIP policy, which is a different kind of life insurance product, the rules can be a bit different. The tax exemption may depend on the kind of funds you have invested your money in. Returns from ULIP equity funds held for more than a year may be treated as capital gains and may be taxed as per the prevalent LTCG (Long-Term Capital Gains) tax. However, one must remember that the investor can opt for fund switching in a ULIP. In such a scenario, calculating ULIP equity returns and taxing them accordingly can get a bit difficult.
The taxation norms of debt funds are applicable as per Section 112 of the ITA. In the event that the returns do not meet the equity fund criteria, the surrender value may be taxed as per debt fund norms.
It is best to connect with a tax expert or a chartered accountant and get a nuanced opinion on the matter before going ahead with surrendering the ULIP policy. One can also use tools such as the ULIP plan calculator and income tax calculator to plan well in advance.