All About Taxability of ULIP on Surrender

Unit Linked Insurance Plans (ULIPs) are valuable financial tools that can be utilised to bridge the gap between various investment possibilities while also providing considerable tax advantages. Since, they combine returns, protection, and tax savings into one package, life insurance products, such as ULIPs, are a more reliable long-term wealth creation solution. ULIPs allow for the taxability of ULIP on surrender of one's premium in a variety of debt and equity funds, as well as inter-fund transfers via switches. The premium for a unit-linked insurance plan (ULIP) is invested in stock, debt, or money market assets.

The majority of individuals check the annual tax advantage before investing in any financial instrument to minimize their tax burden, but it's also a good idea to assess the tax consequences on the maturity of an insurance policy, ULIP, or any other investment. The amount of premium paid for ULIPs is deductible under section 80C, however it's important to remember that ULIPs are taxed when they are surrendered.

ULIP Taxation at Maturity: What's Tax-Free and What's Not?

When your Unit Linked Insurance Plan matures at the end of its term, the total amount received by you or your nominee will be completely tax-free under section 10 of the Income Tax Act (10D). However, the tax benefit is only available if the conditions set forth in the Income Tax Act of 1961 are met in regard to insurance premiums. As for the circumstances, they are as follows :

• ULIPs acquired after April 1, 2012- When the premium is less than 10% of the sum insured, the deduction under section 80C is available, and the amount on maturity is excluded under section 10. (10D). If the premium exceeds 10% of the sum promised, a tax deduction is granted on the amount exceeding 10% of the sum assured, but the entire amount is taxable upon maturity.
• ULIPs acquired prior to April 1, 2012 When the premium is less than 20% of the sum insured, the deduction under section 80C is available, and the amount on maturity is excluded under section 10. (10D). If the premium exceeds 20% of the sum assured, the amount paid at maturity is taxable.

In The Case when The ULIP is Surrendered

• Prior to the lock-in period- If the policy is surrendered before the 5-year lock-in term, the whole surrender value will be considered as income for the current year, added to Gross Total Income, and thus taxed at the individual's applicable tax slab rate
• Post lock-in-period- If the insurance is surrendered after the 5-year lock-in term, there is no surrender charges, and the insured can take advantage of the tax benefit.

The Way ULIPs Work

Unit Linked Insurance Plans provide policyholders with a life insurance payout as well as investment benefits. Policyholders must pay the insurer a premium on a regular basis. The insurer provides coverage to the policyholder so that in the event of the latter's untimely death within the plan's term, the nominee is qualified to receive the death benefits. That covers the insurance aspect.

When it comes to investing, policyholders can choose from a variety of ULIP funds when purchasing a Unit Linked Insurance Plan. There are two types of funds available: equity and debt funds. The market-linked earnings from these investments are paid out to the policyholder at maturity. These are the advantages of maturity.

• Premiums paid for ULIPs can be claimed as a deduction from your total income under section 80C of the Income Tax Act, 1961, but the deduction is limited to Rs. 1.5 lakh. If the policy does not meet the Section 10(10D) requirements, the amount of deduction under Section 80C is limited to 10% of the capital sum assured for policies issued on or after April 1, 2012, and 20% of the capital sum assured for policies issued before April 1, 2012.
• Section 10(10D) of the Income Tax Act of 1961 discusses the tax benefits of maturity. Benefits on ULIP maturity were tax-free until Budget 2021 if specific conditions were met, as detailed in Section 10(10D) of the Income Tax Act of 1961. As a result, now that we're on the other side of the FY22 budget, the taxability of ULIP benefits based on maturity can be divided into two categories: taxability of ULIP on surrender issued before February 1, 2021 and taxability for ULIPs issued after or on 1st February, 2021

ULIPs issued before February 1, 2021

ULIP returns on maturity are tax-free under section 10(10D) of the Income Tax Act, 1961. For plans acquired after April 1, 2012, this is only valid if the annual premium is less than 10% of the capital total assured (for the plans purchased before the said date, it is 20 percent).

ULIPs issued after or on 1st February, 2021

In the budget for FY 2021-22, it was announced that for ULIPs issued on or after February 1, 2021, the proceeds from the plan will now be taxed as capital gain at the time of payments under the policy if the aggregate premium exceeds Rs. 2.50 lakhs in any financial year during the policy's tenure. The only exception is any sum received by the nominee at the time of the policyholder's death, where taxability of ULIP on surrender is not possible. It may be mentioned that top up premium would also be considered for determining annual premium. The keyman policy's death proceeds will be taxed (Employer employee policy). Additionally, long-term capital gains exceeding Rupees One Lakh calculated on the proceeds of ULIPs issued after or on 1st February, 2021, will be taxed at a rate of 10 percent. Note that this only applies if all ULIPs are classified as equity-oriented funds. The government, on the other hand, has yet to provide more details.

Tax on ULIP Surrender After 5 years

What happens if the policy is surrendered before the 5-year lock-in period? The entire surrender value will be recognized as income for the current year, added to gross total income, and therefore taxed at the individual's applicable tax slab rate. Let’s talk with an example, if taxability of ULIP on surrender is Rs. 3,00,000 and overall income apart from surrender value is Rs. 15,00,000, the total income will be Rs. 18 lakhs and the full income will be subject to tax according to the slab rate.

What about the tax implications of surrendering a ULIP after five years? If the insurance is surrendered after the 5-year lock-in term, the surrender value is tax-free, and the insured can take advantage of the tax benefit. As a result, the majority of consumers are concerned about the taxability of ULIP on surrender after 5 years. To answer this question, there will be no charge for surrender and the surrender value will become free of tax once you have finished 5 years. If you surrender your ULIP before five years, the surrender value is added to your income and taxed at the applicable slab rate. It is best to avoid leaving a ULIP as soon as the lock-in period expires. The following are some plausible explanations :

• ULIP charges are substantial in the first few years. In ULIP, there are a few fees. The premium allocation charge is deducted before the premium is invested, while the funds allocation charge, fund management fee, and policy administration cost are deducted by canceling units or modifying the NAV in the case of a ULIP. The deduction is greater in the 1st year and then after that it decreases gradually. By the conclusion of lock-in time and beyond, these charges come down to a point where it doesn’t influence the money. You will also miss out on the genuine benefits if you leave after the lock-in period has ended. In a ULIP, you will receive smaller returns than you would in a traditional investment.
• To get the rewards of ULIP, you must stay in the game. ULIP is a strategy for long-term investment. After 5 years, you can escape the ULIP; nevertheless, even after the lock-in term has ended, it is not recommended. You should continue to invest for a long time, say 15-20 years, to realize the benefits. If you believe your funds are underperforming, you may want to consider switching them. Since, the performance is solely dependent on market swings, as it is in the case of equities, you may wish to wait until the market recovers before withdrawing your ULIP. So, in order to receive the rewards, you should invest for at least 15-20 years.

Key Takeaways

• Understand the purchase date (before or after February 1, 2021) to determine your maturity tax benefits.
• For ULIPs purchased on/after February 1, 2021, keep the total premium within Rs. 2.5 lakhs per year to avoid maturity tax.
• Surrenders before the 5-year lock-in lead to tax implications. Consider the long-term benefits before surrendering.
• Seek professional advice to tailor your ULIP investment to your specific needs and tax situation.