Surrendering pension products? Prepare to pay taxes irrespective of when you surrender

If you surrender a pension product anytime before maturity, will the surrender value be added to your income and taxed as per your slab in the year of surrender? If so, this is even worse that life insurance product surrender before maturity.

As regards the old pension products (pre December 2011), on maturity of the policy, a third of the corpus would be tax–free; the remaining can be invested in an annuity product sold by any insurance company. If the policyholder does not want to invest in annuity, then two-thirds of his pension corpus will be taxable, which is not a good option.

To make matters worse, effective December 2011, IRDA’s (Insurance Regulatory and Development Authority) guidelines for pension products, supposedly to alleviate the problems, may end up aggravating them. IRDA has made annuity compulsory. Earlier, the policyholder had an option to pay tax on two-thirds of his corpus on maturity and not go for an annuity product. The change enforces annuity for the 2/3rd corpus not just on maturity but even on surrender at any time before maturity. The lack of flexibility is a huge constraint. You cannot easily move out of the product even if it is not performing well.

The most important change is that the policyholder is not allowed to choose the insurance company for the annuity phase of the pension product. If his insurer does not offer the best rates, the policyholder is stuck with the same insurance company literally for life. But, annuity is taxable which itself is a big drag. Why would a normal person even fall prey to a pension trap?

Unlike the life insurance pension wherein you can withdraw one-third of the corpus on maturity as tax-free, you can normally exit new Pension Scheme (NPS) only at 60 or later when at least 40% of the pension wealth has to be used to purchase an annuity. (If you leave NPS before you turn 60, 80% of the pension wealth will be annuitised). The remaining 60% can be withdrawn between age 60 and 70. But, the lump-sum is taxable.

Many websites wrongly claim that the lump-sum (60%) is tax-exempt. You are not paying taxes on the gains your NPS investment makes, but on the amount you withdraw prematurely or on maturity. This is a killer. Until NPS gets into EEE category, it is one of the worst pension products. Returns will be destroyed by tax.

Be safe and smart with your insurance
This is just a snapshot on an in-depth, independent research on this topic of done by Moneylife. To read this article in detail, be a premium member today. Click here to be one
 

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