When discussing a term plan with return of premium (TROP), one of the most common selling points is its tax efficiency. The promise of a tax-free refund on all premiums paid at maturity seems like a great deal. While it’s true that the refund is often tax-exempt, this widely held belief can be misleading. It’s a myth that needs busting. Understanding the specifics of the Indian Income Tax Act is crucial to making an informed decision about your term insurance policy.
The Reality of Tax Exemption on a TROP Refund
The tax exemption on the maturity benefit (the refund) of a term plan with return of premium is governed by Section 10(10D) of the Income Tax Act. This section states that any amount received under a life insurance policy, including a bonus on a maturity or surrender, is exempt from tax, provided certain conditions are met.
For policies issued after April 1, 2012, the primary condition is that the annual premium should not exceed 10% of the sum assured. If this condition is not met, the maturity benefit becomes taxable.
The Catch: The Premium vs. Sum Assured Calculation
This is where the myth starts to unravel. A TROP, by its very nature, has a significantly higher premium compared to a pure term insurance plan for the same sum assured. In many cases, especially for larger cover amounts or for individuals in their middle age, the annual premium for a term plan with return of premium can easily cross the 10% threshold of the sum assured.
Let’s illustrate with an example:
- Pure Term Insurance: You buy a ₹1 crore term policy for an annual premium of ₹12,000. Here, the premium is just 0.12% of the sum assured. This easily meets the Section 10(10D) criteria.
- Term Plan with Return of Premium: You buy a term plan with return of premium with the same ₹1 crore cover, but the annual premium is ₹35,000. In this case, the premium is 0.35% of the sum assured, also meeting the criteria.
However, consider an older individual who buys a similar TROP. Their annual premium might be ₹1,50,000 for a ₹10 lakh sum assured. Here, the premium is 15% of the sum assured, which exceeds the 10% limit. In this scenario, the TROP refund at maturity will be fully taxable.
The Deeper Implication: The Opportunity Cost
Even if your term plan with return of premium refund is tax-free, it doesn’t mean it’s a good deal. The “tax benefit” on the maturity amount is often a mirage. The extra premium you pay for a TROP could have been invested in a separate instrument, such as a mutual fund SIP, to generate real, inflation-beating returns. These returns may be taxable, but the net amount you get from a disciplined, long-term investment strategy is likely to be far greater than the simple premium refund from a TROP.
The Smart Financial Move
The golden rule of financial planning is to separate insurance from investment. A pure term insurance policy is the most efficient and cost-effective way to secure your family’s financial future. The death benefit is always tax-free under Section 10(10D), irrespective of the premium paid. By choosing a pure term plan, you save on premiums and can invest the difference in a proper investment avenue. This strategy not only protects your family but also builds genuine wealth for you.
So, while the promise of a tax-free refund on your term plan with return of premium may sound appealing, it’s a feature that comes at a high cost and may not even be tax-exempt in all cases. Make your financial decisions based on sound logic, not on popular myths.
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