The market is awash with a number of insurance policies that yield varied returns based on their objectives. Though most offer a fixed return, in case of unit-linked policies (ULIPs) the return is unpredictable as it depends on the fund performance. Hence, it becomes a tad difficult to distinguish between two ULIPs on the basis of their returns only. Here comes in the tax factor. The final impact of tax implications on our returns can help us evaluate a ULIP better.

Radhika, 35, is deciding between an insurance policy that will provide her with good returns and a pension policy that will take care of her retirement years. She is a salaried employee with a private firm and earns around Rs 5 lakh a year. She has her eyes set on an endowment policy that will provide her with money when she turns 60 in case she survives till that age. In comparison, the pension policy will provide her with a regular payment after she retires.

Analysis
Radhika is scrutinizing two ULIP plans - endowment and pension - that fit her requirements. Since these policies are market linked, the amount she will receive at the end would relate to the value of the fund (NAV) at that time. The growth of the NAV in turn will depend upon the type of assets allocation selected in the form of the nature of the fund and the way in which this is managed. So, it is imperative for her to see how much amount she will get in hand after deduction of taxes, if any.

Now, let's take a closer look at the actual tax impact and how this will influence the position for Radhika.

Endowment policy

Under a special provision in the Income tax Act, the returns on an insurance policy are tax free.
There will be two possibilities, if the policy is other than a term policy.

a) On untimely death of the insured
In this situation, a benefit can be received on the death of the person insured under the policy. This receipt is tax free in the hands of the dependants who actually receive the insurance benefit. This means that under Section 10 (10D) of the Income Tax Act the amount received on death from an insurance policy will not be included in the taxable income calculations.

b) On maturity
In this case, the amount would be received at maturity of the policy. It would include bonus and other benefits. This happens when the policyholder actually lives through the entire policy period, for example, in moneyback policies or endowment policies. In this case too the receipt is completely tax-free in the hands of the investor.

Example
Consider a case where Radhika takes a policy with a sum assured of Rs 10 lakh cover. At maturity after 20 years, the total amount including bonus comes to Rs 21 lakh. The bonus is accumulated at different rates for the years over the life and this works out to Rs 11 lakh totalling to an overall figure of Rs 21 lakh; this entire amount is tax free.

Pension policy

Radhika will receive a lump sum, usually, one-third of the total payable amount, and this amount is tax free. She has to invest the remaining amount in an annuity plan. Considering a maturity amount of Rs 21 lakh, an amount of Rs 7 lakh will be received as lump sum and remaining Rs 14 lakh has to be invested in an annuity plan. Considering an investment of Rs 14 lakh in a standard annuity plan (currently existing in the market) will give her a return of Rs 99,568 per annum. However, if the whole maturity amount of Rs 21 lakh is invested in the annuity plan, the annuity amount would increase to Rs 1,49,352 per annum.

The pension received will be taxable, and the entire amount will be included as the income from other sources. That is, Radhika will have to pay income tax on her pension depending on her income slab. This can dent the final earnings from this source.

Besides this, if Radhika thinks her policy is not performing well in comparison with other plans, and decides to exit the plan, she will have to pay not only the surrender charge but also the tax amount on the entire amount received.

Example
If Radhika has a pension policy that pays out Rs 15,000 per month each year till the time that she lives then the amount of Rs 1,80,000 would be taxable and included in the taxable income each year.
Note: The actual amount of tax on this figure would differ depending upon the other income and circumstances of the case.

Action
Other policies get a favourable treatment as compared to pension policies in terms of tax benefit but this does not mean that every person like Radhika should avoid the pension policy. In case of early death the insurance policy can provide relief to dependants while in case of a long life the pension policy provides a regular source of income.