In general, insurance distributors report a whopping deal in the January-March quarter as this is the period when taxpayers make the mistake of buying life insurance for the purpose of tax savings. This is how you can enjoy the tax deduction savings benefit €1.5 lakh under Section 80C of the Income Tax Act, taxpayers tend to take out an expensive insurance policy that they don’t need. This post is about why buying life insurance as a tax saving product is not a good choice and what you should do.
Adhil Shetty, Managing Director of BankBazaar.com says, “Haste leads to poor investment and insurance decisions.” Therefore, you must first understand both needs and decide what to buy. Insurance must be purchased primarily to cover your risks Tax savings are secondary and should not be the focus of your purchase.
Many investment options offer better returns than life insurance at a lower cost under Section 80C of the Income Tax Act. For example, the Sukanya Samriddhi Yojana Scheme, Public Provident Fund (PPF) and National Savings Certificate (NSC) currently offer annual interest rates of 7.6%, 7.1% and 6.8%, respectively.
While the PPF and Sukanya Samriddhi Yojana schemes have no costs (fees) at all, Equity Linked Savings Scheme Mutual Funds (ELSS) have ongoing costs of up to 2.25% but can generate inflation-linked returns. Traditional life insurance policies cost more and only offer a return of around 4-5%. You get a small share of traditional life insurance policies because you pay a significant percentage of the policy cost to brokers.
For example, if a 35-year-old man took out traditional life insurance for 25 years, he would have to pay a premium of around €47,000 per year for coverage of €10 lakhs. If he survives, he gets about the expiry benefit of €19 lakhs. In this case, the internal rate of return (IRR) is only around 4%.
So the next time your insurance agent offers you a traditional policy, ask them to calculate the IRR on the Excel spreadsheet. This process will help you determine the projected rate of return you will receive on the insurance policy. It will come as no surprise to you that insurance policies in this day and age can also offer a 2-3% return.
That being said, financial experts also say, “One should not consider taking out term life insurance to take advantage of tax benefits, as it will save you a minimal amount.” For example, if a 35-year-old non-smoker takes out term life insurance with a contract term of 25 years he has to pay a premium of approx €16,000 per year (approx) for coverage of €1 crore. This further implies that even if he is in the top tax bracket, he can only save €4,800 (excluding Cess fees) under Section 80C. Therefore, he should not think about taking out term life insurance for the purpose of tax savings.
You also need to know that life insurance requires a long-term financial commitment. What if your salary increases and you take out a home loan three years after getting life insurance? There are times when your Section 80C limit can quickly be exhausted by the employee provident fund (EPF) and home loans. In such cases, you end up paying a hefty insurance premium every year knowing you no longer need a policy to save on taxes. Therefore, this season, don’t make a mistake by rushing to buy traditional life insurance, which often doubles as an investment plan. “Ideally, you should separate the two needs. Term life insurance and a mix of ELSS and tax-saving investment provident fund almost always provide better coverage and investment returns at a lower cost,” Shetty said.
Understand when you should get life insurance: The purpose of life insurance is to ensure that your loved ones have enough money to meet their income needs after your death. Often this means coverage of 10 to 20 times your current annual income. The least expensive way to get this substantial coverage is with term life insurance.
Shetty said: “You need to take some time to understand what your life insurance needs are. For example, you may need to meet your spouse’s income needs, your children’s educational needs, your parents’ health care needs, and family debts such as car or home loans. You may also need to assess additions such as accidental death, serious illness, or monthly income. If you rush to buy life insurance, you miss an opportunity to evaluate your needs and options.”
Similarly, Mahavir Chopra, Founder and CEO of Beshak.org, said, “Tax savings are a tactical, short-term component of the overall benefits you get from purchasing insurance. Shopping in a hurry is likely to distract you from solving the core problem an insurance plan solves – your family’s long-term financial security! Focus on your family’s long-term financial protection first, and then look at the bells and whistles like taxes etc.”
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