Why you should never buy insurance to save tax

Generally, in the January-March quarter, insurance distributors report a colossal business as this is the period when taxpayers make the mistake of buying life insurance for tax savings purpose. To get the tax deduction savings benefit of ₹1.5 lakh under Section 80C of the income tax act, taxpayers tend to buy a high-cost insurance policy that they don’t need. This piece looks at why buying life insurance is not a good choice as a tax-saving product and what you should do.

Adhil Shetty, chief executive, BankBazaar.com, says, “Haste breeds bad investment and insurance decisions." Hence, you must first understand both needs and decide what you want to buy. Insurance needs to be purchased primarily to cover your risks. The tax savings are incidental and should not be the focus of your purchase.

Many investment avenues offer better returns than life insurance at a lower cost under Section 80C of the income tax act. For instance, Sukanya Samriddhi Yojana Scheme, Public Provident Fund (PPF) and National Savings Certificate (NSC) currently offer an annual interest rate of 7.6%, 7.1% and 6.8%, respectively.

While the PPF and Sukanya Samriddhi Yojana Scheme incur no costs (charges) at all, equity-linked savings scheme (ELSS) mutual funds, on the other hand, incur running expenses of up to 2.25% but can provide inflation-beating returns. Traditional life insurance policies incur a higher cost and offer only approximately 4-5% yield. You get a low take on traditional life insurance policies because you pay a significant percentage of the policy cost to brokers.

For instance, if a 35-year old male buys a traditional life insurance policy for 25 years, he will have to pay a premium of around ₹47,000 per year for a cover of ₹10 lakh. If he survives, he will approximately get the maturity benefit of ₹19 lakh. In this case, the Internal Rate of Return (IRR) will only be nearby 4%.

So, next time your insurance agent offers you a traditional policy, ask him to calculate the IRR on the excel sheet. This process will help you know the projected yield you get on the insurance policy. It won’t surprise you that insurance policies can also offer a 2-3% yield in today’s time.

Apart from this, financial experts also say, “One should not consider buying term insurance for doing tax benefit as one saves a minimal amount by doing so." For instance, if a 35-year old non-smoker male buys a term insurance policy for a policy term of 25 years, he will have to pay a premium of around ₹16,000 per year (approximately) for a cover of ₹1 crore. This further implies that even if he is in the highest tax bracket, he can only save ₹4,800 (excluding cess charges) under section 80C. Hence, he should not think of buying term insurance for tax saving purposes.

You must also know that a life insurance policy requires a long-term financial commitment. What if your pay increases and you take a home loan three years after buying a life insurance policy? There are times when your section 80C limit can quickly get exhausted by employee provident fund (EPF) and home loans. In such cases, you will have to forcefully pay a hefty insurance premium every year despite knowing that you don’t require a policy to save tax anymore. Hence, you shouldn’t make a mistake this season by rushing to buy traditional life insurance that often doubles up as investment plans. “In the ideal scenario, you should separate the two needs. A term cover for life insurance and a mix of ELSS and provident fund for tax-saving investment almost always provides better coverage and investment returns at lower costs," said Shetty.

Understand when you should buy life insurance: The purpose of life coverage is to ensure your loved ones have ample money to meet their income needs after your demise. Often this means having a cover of 10-20 times your current annual income. The most cost-effective way to achieve this sizeable coverage is term insurance.

Shetty said, “You need to take some time to understand what your life coverage needs are. For instance, you may need to cover your spouse’s income needs, children’s education needs, your parent’s health needs, and the family’s debts such as a car or home loan. You may also need to assess add-ons such as accidental death, critical illness, or monthly income. If you buy life insurance hastily, you will miss the chance to evaluate your needs and options."

Echoing similar views, Mahavir Chopra, founder and CEO, Beshak.org, said, “Tax saving is a tactical, short-term component in the overall benefits that you get from buying insurance. When you buy in a hurry, you are likely to get distracted from solving the core problem that an insurance plan solves —your family’s long-term financial security! Focus on long-term financial protection for your family first, and then look at the frills like tax, etc."