Definition
Surrendering a life insurance policy means voluntarily terminating the policy before its maturity date. When you surrender a policy, the insurance company pays you the surrender value, which is the amount you receive after deducting various charges, such as administrative fees and surrender penalties, from the accumulated premiums. Surrendering a policy is different from letting it lapse, as the latter happens when you stop paying premiums without formally terminating the policy.
Why Do People Surrender Their Life Insurance Policies?
Policyholders may choose to surrender their life insurance policies for several reasons:
Financial Constraints: Inability to continue paying premiums due to financial difficulties.
Change in Priorities: The policy may no longer align with their financial goals or needs.
Better Investment Options: Policyholders may find other investment avenues that offer higher returns.
Policy Underperformance: Dissatisfaction with the policy’s performance or returns.
How Does Surrendering a Policy Work?
- Surrender Value: When you surrender a policy, the insurance company pays you the surrender value, which is calculated as:Surrender Value = (Total Premiums Paid + Bonuses (if any)) – (Surrender Charges + Administrative Fees)
Surrender Charges: Most insurance companies impose surrender charges, especially if the policy is surrendered within the first few years. These charges decrease over time.
Tax Implications: The surrender value may be subject to tax, depending on the policy type and the duration for which it was held.
Advantages of Surrendering a Policy
Immediate Liquidity: Surrendering a policy provides immediate access to funds, which can be useful during financial emergencies.
No Further Premium Payments: You are relieved from the burden of paying future premiums.
Simplifies Finances: If the policy no longer serves your needs, surrendering it can help streamline your financial portfolio.
Risks to Consider
Loss of Coverage: Surrendering the policy means losing the life insurance coverage it provides.
Lower Returns: The surrender value is often significantly lower than the total premiums paid, especially in the early years of the policy.
Tax Implications: The surrender value may be taxable, reducing the net amount you receive.
Taxation
Understanding the tax implications of surrendering a life insurance policy is crucial for Indian policyholders. Here’s how taxation works:
Taxation Under Section 10(10D):
Exemptions: If the surrender value is received from a life insurance policy where the annual premium does not exceed 10% of the sum assured (for policies issued after April 1, 2012), the amount is tax-free under Section 10(10D) of the Income Tax Act.
Taxable Cases: If the annual premium exceeds 10% of the sum assured, the surrender value becomes taxable.
Taxation of Surrender Value:
Taxable Component: The surrender value is taxed as “Income from Other Sources” in the year it is received.
Tax Deduction: The premiums paid over the years are deducted from the surrender value to calculate the taxable amount.
- Example of Taxation:Let’s say Mr. Kumar surrenders a policy after paying ₹2,00,000 in premiums over 5 years and receives a surrender value of ₹1,50,000. If the policy does not qualify for exemption under Section 10(10D), the taxable amount would be:Taxable Amount = Surrender Value – Premiums Paid = ₹1,50,000 – ₹2,00,000 = (-₹50,000)Since the result is negative, no tax is applicable in this case. However, if the surrender value were ₹2,50,000, the taxable amount would be ₹50,000, which would be added to Mr. Kumar’s income and taxed as per his applicable tax slab.
Key Considerations:
- Policy Duration: Surrendering a policy within the first few years often results in higher surrender charges and lower surrender values.
- Consult a Tax Advisor: It’s advisable to consult a tax advisor to understand the specific tax implications based on your policy and financial situation.
Example
A common example in India involves traditional endowment policies, which are popular among Indian households for their dual benefit of insurance and savings. Let’s say Mr. Sharma purchased a 20-year endowment policy from LIC (Life Insurance Corporation of India) with an annual premium of ₹50,000. After paying premiums for 5 years, he faces financial difficulties and decides to surrender the policy.
Upon surrendering, Mr. Sharma receives a surrender value of ₹1,80,000, which is significantly lower than the total premiums paid (₹2,50,000). Additionally, he loses the life cover and potential bonuses that would have accrued if he had continued the policy. This example highlights the trade-offs involved in surrendering a life insurance policy and the importance of evaluating all options before making a decision.
Summary
Surrendering a life insurance policy can provide immediate liquidity and relieve you from future premium payments, but it comes with significant trade-offs, such as loss of coverage, lower returns, and potential tax implications. Before surrendering your policy, it’s essential to evaluate your financial situation, explore alternatives like paid-up policies or loans against the policy, and consult a financial advisor if needed.
Whether you’re facing financial difficulties or reassessing your financial goals, understanding the implications of surrendering a life insurance policy can help you make an informed decision.
In a lot of cases in India, surrendering does make sense since the policies were mis sold to the beneficiaries, and it is best to come out of a mis sold product at the earliest possible to avoid further costs of lost opportunities. Your financial advisor will be your best pal in taking this decision.
Reference Links:
Book: From the Rat Race to Financial Freedom
Book: FOOPS!
A subject which affects all of us, however few of us know about its repercussions. Thanks Mr. Manoj for valuable insight.
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