The financial year-end sees an uptick in life insurance purchases. Apart from coverage and investment benefits, life insurance policies also provide tax deductions under Section 80C of the Income Tax Act. Owning a life coverage is critical for persons with dependent family members.

An insurance coverage replaces the income of the deceased, thus helping dependants avoid financial strain and remain on track to achieve life goals such as paying off a home loan or educating a child. Therefore, the coverage size needs to be at the heart of an insurance purchase decision. This is not often the case. For many, the need to save taxes, along with the tendency to combine insurance needs with investment needs, take precedence. Not prioritising the sum assured could have disastrous consequences for their families.

The preferred approach

Many prefer having streamlined solutions to tax-saving, investment and insurance. This leads them to investment-linked insurance plans that can achieve all the three goals. The policies do a good job of taking care of the tax-saving needs. However, they may also contain the trio of inadequate coverage, limited liquidity and low annualised returns.

Therefore, if you are in the market for your first life insurance policy, buy a term insurance plan. It’s a pure insurance plan with no investment or maturity benefit. Because of the low premium costs, this is the only option that takes care of your coverage needs without pinching your wallet. For example, a 30-year-old can buy a basic term cover of Rs 1 crore for 30 years for an annual premium of around Rs 11,000. At that price, it wouldn’t be possible to buy a similar coverage through investment-linked policies. A term plan would also free up your savings that you can now use for wealth creation.

How much coverage?

There are many ways of determining the ideal level of coverage.

Some suggest a simple rule of thumb: coverage of 10 to 20 times your current annual income should cover your family for the long-term. However, it’s better to calculate your requirement keeping in mind your financials, life goals and inflation. For example, your minimum coverage need would combine the following: your current annual expenses multiplied by the number of years left till retirement, the current value of life goals such as child’s education, loans and other liabilities, surviving spouse’s retirement needs, minus existing savings and investments.

Bear in mind that your coverage will be commensurate to your documented income. For example, if your income is Rs 10 lakh, you can buy a Rs 1 crore cover, but you cannot buy a Rs 10-crore cover. You may be allowed to own up to 30 times your annual income as coverage in some cases.

What about investments?

Investment-linked insurance plans often have large premium. But a term plan is cheap; it will only provide moderate support in helping you achieve tax-saving goals. Therefore, you need to find options to cover the shortfall in tax savings.You have plenty.

If you were interested in market-linked investments, you could invest in equity-linked savings schemes — tax-saving mutual funds that you can invest in with monthly SIPs, or one-time lump-sums.

ELSS funds also have the lowest lock-ins of tax-saving investments — just three years. If you are risk-averse and prefer the rate of return to be clearly advertised, small saving schemes are your best option because they provide higher tax-free interest income than other debt investment options.

Voluntary Provident Fund, Public Provident Fund and the five-year National Savings Certificate will do the trick for the general public. For families with female children, Sukanya Samriddhi is the go-to option.

Investing through insurance

When you buy any investment, you must understand what its annual rate of return would be. This is important in the short term but even more important when committing to a long-term investment plan such as a Ulip or an endowment plan.

For example, your office PF provides tax-free returns of 8.50 per cent. If you commit to a monthly investment plan of Rs 5,000 for 8.50 per cent for 30 years, you will have a corpus of Rs 83.1 lakh. But if you committed to this plan and it returned just 5 per cent over 30 years, you will get just Rs 41.8 lakh and miss a life goal by a large margin.

Therefore, it’s important that long-term plans provide good results. Endowment plans guarantee a minimum sum assured on maturity. The key is in knowing if the annual rate of return on this investment would beat a benchmark. For example, the 8.50 per cent you get on VPF or 7.1 per cent on PPF. If it doesn’t, you should strongly consider separating your insurance from your investments.

The other thing you need to be mindful of is that you can’t liquidate insurance plans prematurely without suffering a degree of loss. Therefore, if the rate of return and liquidity are critical to you, it would be better for you to invest through other means such as ELSS and PF.

A combination of a term plan plus investments such as ELSS (or PF for the risk-averse) may give you the benefit of ample coverage, high tax-free returns and liquidity when you need it.

The writer is CEO, BankBazaar.com