Tax on surrender of an endowment policy

In present times, life insurance policies are a critical component in financial planning. While most people focus on increasing their investment when planning for the future, it also involves ensuring protection in case things go down south. In these situations, a life insurance policy is what helps to financially support your dependents to avoid them slipping into a debt trap.

Life insurance can be divided into two broad categories — pure life insurance policies and endowment policies — based on the features they provide. A pure insurance plan (term insurance policy) provides protection only for the life of the insured, whereas the endowment plan has investment and protection as its joint objectives.

It is necessary to buy a life insurance policy for robust financial planning. But there can be situations when you may need to surrender your policy. Policy surrender is a process wherein the policyholder opts out or cancels the insurance cover. Thus, the insurance policy ceases to provide any coverage once surrendered.

Tax implications on surrendering an endowment policy

Surrendering your bad investments, or the ones that aren’t supporting you well, can be a prudent decision instead of continuing to shoulder their burden. But at this time, it is most likely that a chunk of your invested amount will be deducted as a penalty. Even after this deduction, it can be wise to give up the investment. However, tax implication is something you must be aware of apart from the penal charges that are levied.

For starters, it is only the surrender value that is paid by the insurance company. This surrender value is only paid after two years of premiums have been paid. The insurance company does not pay any other amounts. On top of it, the surrender value attracts tax provisions subject to certain conditions.

For all policies purchased after 1st April 2012, the surrender value is exempt from tax only if the sum assured is 10 times its annual premium. For instance, a policy has a ₹ 2 lakhs annual premium. Then, the sum assured for such a policy must be at least ₹ 20 lakhs.

For policies that are purchased between 1st April 2003 and 31st March 2012, the surrender value is exempt from taxes only if the sum assured is five times its annual premium. However, for an endowment policy bought prior to 31st March 2003, the entire amount of surrender value is tax-free.

The endowment policy enjoys the exemption of its surrender value under Section 10 (10D) of the Income Tax Act, 1961. Moreover, the premiums paid on these policies can be availed as a deduction under Section 80C of the Income Tax Act. Thus, the surrender, as well as the premium of an endowment policy, can benefit you in your tax returns (subject to conditions).

Is it a smart choice to surrender your endowment policy?

It is generally not advisable to surrender your life insurance coverage due to the following reasons:

Surrendering your policy will leave you exposed to any risks against which your policy provides coverage. While you can always choose to buy another policy, you are exposed to the perils till your new plan is approved.
There is a possibility that your new insurance plan may cost you more. It is due to reasons like increasing age, worsening health conditions, and even more pre-existing diseases at the time of purchase.
Lastly, any premiums that you have already paid for your endowment plan will be lost. While the endowment plan may pay a surrender value and you can gain it from the new insurance coverage that you will buy, it sure is a significant risk.

What are some of the reasons to surrender an endowment policy?

There is no one particular reason for which policyholders may choose to surrender their plan. Change of jobs, no more beneficiaries to provide coverage, and coming across a better policy are some of the common reasons for surrendering a plan.

For instance, if you change your job and your employer offers better coverage at a more affordable price, it is better to reduce your current expenditure by cancelling your existing insurance plan.
Next, if you no longer have any dependents that need to be supported in your absence, it is best to surrender your policy. Since as a policyholder, you cannot avail any benefit from the death benefits that your policy provides, it can be a smart choice to surrender your policy instead. In this situation, you can make better use of the funds in alternative investments.
Lastly, gaining the cash surrender value may be a reason why policyholders may surrender their insurance plans.

While there are different reasons to surrender a policy, you can make use of a life insurance calculator to know the surrender value that may be paid before cancelling your policy.