When you are investing in a financial instrument, it is important to look at several other factors besides the returns to gauge its profitability. Understandably, returns are the main determinant in an investment scenario; however, another vital aspect that should not be overlooked is taxation. If an instrument has high taxation, then there are chances of losing a major chunk of returns to it. 

A beneficial instrument in this regard is the ULIP or Unit Linked Insurance Plan. Besides offering a mix of insurance and investment under one product, it also offers considerable tax benefits. The returns of a ULIP are taxed. However, this taxation is subject to various terms and conditions. Let’s learn more about the same in this article. 

How does a ULIP work? 

A ULIP is essentially an insurance product that offers the policyholder an opportunity to invest in the financial instruments of their choice. The premiums paid for a ULIP are divided into two uses – one part is used to create the life cover and the other part is used for investment. The latter portion is pooled with money from other policyholders, and each investor is assigned a number of units as per their share of the pooled amount. 

One can invest in equity or debt ULIPs, or even opt for a mix of both via balanced funds. Equity funds yield higher returns on average at the cost of more risk, while debt funds are preferable for those with a low-risk appetite. The returns for each kind of asset class can be calculated with the help of a ULIP calculator. 

The taxation on returns can also differ depending on the kind of instrument in which the instrument was made. 

Tax exemption on ULIP proceeds 

As per Section 10 (10D) of the Income Tax Act of 1961, the returns a policyholder receives from a ULIP are exempted from taxation. This taxation is subject to several terms and conditions. Nevertheless, this particular tax benefit makes a ULIP an appealing option for tax-savvy investors in comparison to other investment options. 

The above benefit received a major amendment with the Budget 2021. As per this amendment, ULIP returns are taxable if the yearly premium of the plan goes above Rs 2.5 lakhs. This ULIP taxation is applicable even if the premium exceeds this limit for a single year of the plan.

  • No taxation on death benefits 

The taxation limits are valid only for the gains that your ULIP attains via investment. The death benefit amount that the beneficiaries receive on the demise of the policyholder is exempted from taxation on all grounds. 

Deduction on ULIP premiums

Apart from tax exemption on ULIP returns, this type of insurance coverage offers another promising tax benefit. Section 80C of the ITA outlines several financial instruments and expenses which can help you claim tax deductions. Life insurance plans are one such instrument. Since ULIPs come under the life insurance category, one can claim Section 80C deduction.

The premiums paid towards your ULIPs can be claimed as deductions up to a maximum of Rs 1.5 lakhs. However, as with Section 10 (10D) ULIP taxation, there are terms and conditions here as well. 

If the plan has been bought before April 1, 2012, then the premium must be less than 20% of the claim amount to enjoy the deduction. If the policy has been bought after April 1, 2012, then the premium must be less than 10% of the claim amount to be eligible for this deduction. 

Things to note about taxation on ULIPs

  • As some may know, ULIPs have a lock-in period of five years. The policyholder cannot withdraw the money from the plan until the plan has completed at least five years. After the end of the lock-in period, the policyholder can make partial withdrawals on their plan. These partial withdrawals are also exempted from taxation. 
  • Another thing to note about the lock-in period is that if the policyholder surrenders the policy during this period, the tax benefits they may have gained until now may be reversed. 
  • The tax benefits mentioned in the article may not be applicable if you are opting for the new tax regime since many tax exemptions and deductions have been scrapped within the new regime. 

Do read the terms and conditions of the policy before signing it. Ensure to use tools such as the ULIP calculator to make well-informed decisions. Tax benefits are subject to amendments in tax laws. Consult a tax professional before proceeding.