Individuals, who invest their savings in annuity plans offered by insurance firm, could see a drop in their tax burden.

Insurance regulator IRDA is in talks with the government to make annuity-plans more tax-efficient. If the proposal is accepted in the coming budget, it will augment returns for retired employees and help insurers market these plans better. An annuity is a contract issued by an insurer to make regular payments to a policyholder for the rest of his life after retirement. The frequency of payment depends on the way the policy is structured.

Going by the existing income-tax law, an individual can claim a tax deduction of up to Rs 1 lakh on the premium (or the principal contribution) paid for the annuity plan. But the payments received by the individual, annuitant in technical parlance, are fully taxed. The tax rate depends on the slab in which the taxpayer falls, with the maximum marginal rate at 30%.

The insurance regulator has asked the finance ministry to consider bifurcating the principal and the interest component in payments made to annuitants. "We have asked the government to consider making the principal component tax-free," J Hari Narayan, chairman, Insurance Regulatory Development Authority, told ET.

The rationale for a tax exemption on the principal component is the amount has already been taxed. In fact, many countries do not levy a tax on the original contribution in an annuity plan. Revenue officials, however, contend that the payment received by the annuitant is treated as his income, and hence, fully taxed.

But the regulator reckons that the tax burden could be a dampener for investments in annuity plans. "Annuity plans need to be made more tax-efficient to promote long-term savings which can be used for infrastructure investments," said R Kannan, member actuary, IRDA.

The regulator's proposal will enhance returns for investors, said the chief financial officer of a private insurance company. An employee, for instance, then is taxed only partially on the money he receives from an approved superannuation fund, according to Divya Baweja, partner, BMR & Associates.

The regulator has also sought more avenues for investments in long-dated government securities to help insurers in their asset-liability management, said Mr Narayan.

IRDA's budget wishlist also includes easing the service tax burden on unit-linked insurance plans that offer protection in terms of life cover and flexibility in investments to the policyholder. Currently, insurers have to pay service tax on the charges they collect for managing Ulip investments.

Mutual funds, on the other hand, pay service tax only on the asset management charge. The regulator wants a similar dispensation in Ulips. The global economic meltdown has impacted investments in ULIPs, which contribute to around 70% of the new business for insurers.