ULIP vs Mutual fund – Where to invest in the new LTCG tax Regime?

ULIPs or Mutual funds, what to choose? This is a very old debate which till now Mutual funds have been winning. But with the Long-term capital gain tax been announced in Equity Mutual funds w.e.f 1^st April 2018, Investors have once again asked the same question and are looking for a better suited Tax-free option.

Of course, Taxation is one of the big criteria while investing in a product. But that should be considered along with the Costs, Liquidity, Flexibility, and Management.

With Equity investments be it shares or mutual funds are taxable now, Unit Linked Insurance Plans have gained an edge over them as ULIP returns with some conditions are still tax-free in the hands of investors.

It’s not about only returns but the switches between the different funds within a ULIP are tax-free, unlike Mutual funds where if you switch out from one scheme will be considered as redemption and will attract tax.

Even if you have invested in a debt option in a ULIP, your maturity or switches will remain tax-free as per existing rules, whereas in mutual funds if you are a debt fund investor then the short-term capital gain will be taxed as per the Income-tax slabs and LTCG will be taxed at 20% after indexation.

So, does all this mean that ULIPs are now better than Mutual funds and Investors should move their money from Mutual funds to ULIPs?

Well, this is what we have to find out.

As I wrote above, though taxation is an important parameter while selecting any investment, this is not the only one.

One should also look at the costs which will impact the returns in a big way, Liquidity which helps manage the emergency situations well and also helps an investor take advantage of other opportunities, and flexibility.

Let’s understand these factors one by one.

ULIP Vs Mutual fund – Basic feature comparisons

Costs:

The Inherent costs of an investment product has a lot of bearing on its returns. If both ULIP and Mutual funds have invested in Equity, with the same kind of portfolio giving the same return, then the actual return that investor will get depends on the Costs deducting out of the Returns.

Mutual funds have expense ratio ranges from .10% – 3.00%, depending on the type of fund you are invested into and the corpus that fund is having.

These costs are governed by SEBI and all the expenses of Mutual fund houses, which may be Fund management expenses, distribution costs, AMC expenses, etc. all will be taken care of in this range.

Whereas in ULIPs there are Allocation Charges to compensate the distributors for selling the product; administrative charges; Fund management charges; Mortality charges (as a cost to provide Insurance cover); Plus, GST on all these charges.

All these charges combined together prove to be a big burden on the return which investor gets.

However, one thing to note here is that ULIP space is improving a Lot. Insurance companies are coming up with unique products with less or no charges.

There is one such product by HDFC called Click 2 invest which has only Fund management charges (1.35%) and Mortality costs which are required to keep the insurance cover intact and keep the Insurance maturity proceeds tax-free.

Such products and many of such coming up in future will give a decent competition to Mutual funds.

Liquidity:

To me, liquidity is the prime concern in any investment product. I do not like lock-in periods. An investor should always have the option to come out of any investment even if at some charges.

I mean if I do not find the product suitable or if I need money for my requirements, the ULIP structure forces me to stay invested for at least 5 years. I have no option to take my money out.

Just imagine if the ULIP you have invested in is not doing so well in comparison to the other investments, you have no option but to stick with it for the first 5 years at least. And this is not all you have to keep investing too else this will make your complete money taxable at the time of withdrawal.

Whereas Mutual funds are very much liquid unless you have invested in some close-ended scheme. Though close-ended schemes get listed in the stock markets, in that case, liquidity depends on the availability of the buyer.

Management:

From the Investment management angle when you invest in a product, besides past performance you would like to understand the view of the fund management, the past track record of the fund manager, you would like to review the portfolio and watch the portfolio churning, you may like to meet the fund management, some ready data which may guide you on the consistency of the fund, rolling returns, some researchers or analysis… All these things are not available in the case of ULIPs.

You may find their portfolio on the websites but that is quarterly updated.

The insurance industry may have investment products, but they still think from the Insurance angle only. If they want investors to come into their products, then they have to increase their transparency and regular disclosures.

They Should be open to get their investment funds reviewed and rated by third parties and also increase the Interaction of the fund management team with the Investors and advisors to help them have a better understanding of their strategies. All this is still missing in the Insurance sector.

Flexibility:

This is another concern when you get a lock-in product. While doing goal-based planning, and designing the Investment structure I have found in many cases that Investors do not have enough money to invest at the start but going forward they expect a regular raise in their Income which would keep supplementing the savings.

In such cases, I design an Incremental savings structure for them through automatically incrementing SIPs. Like their SIP values keep increasing by 10% every year and all this is automatic. Reasonable from an investor’s point of view and comfortable for the one who is implementing.

Such kind of flexibility is not there in the case of ULIPs. You can’t increase the premium payments every year. Every time You would have to buy another policy. Though you can do the top-up in case you have lump sum money, but that again will attract all kinds of costs.

Taxation:

Yes, this is also one of the important points to understand before deciding on which is better ULIP or Mutual funds.

The debate has restarted from taxation angle only which says that from April 2018 onwards the long-term capital gains from equity Mutual funds (Over and above Rs 1 lakh) will be taxed at 10 %, but in the case of ULIP, it is completely tax-free only if the annual premium is less than 2.50 lakhs and purchased before 1st Feb 2021.

This is true. But you have to understand that in the case of ULIP, the “No tax Feature” comes at a cost.

And that cost is the Insurance (Mortality) cost and the Compulsory Premium payment costs.

In ULIPs or endowment plans, the minimum insurance cover should be 10 times your annual premium payments, in other words, the premium should not be more than 10% of the Insurance cover the policy has.

If the Insurance cover is not 10 times the premium then complete maturity proceeds would be taxable under section 10(10D), which does not apply.

In Budget 2021, it is proposed that the provision under section 10 (10D) would also not be applicable on ULIPs purchased after 1st Feb 2021 where the annual premium is higher than Rs 2.50 lakh. In the case of multiple policies if the total aggregate premium paid is higher than Rs 2.50 lakh then the maturity proceeds of all the policies would be taxable. (Read: New Rules for ULIP Taxation after Budget 2021)

The maturity proceeds of such policies would be taxable under capital gains at par with equity mutual funds. However, the amount receivable on Death continues to be tax-exempt.

(Also Read: Taxation of Mutual Funds)

This is not all, if you stop paying the premium during the continuation of your Policy, due to which the Insurance cover is reduced or lapses as per the Policy conditions, and then you surrender the policy, this also will make the complete surrender proceeds taxable in your hands, as at the time of surrender the insurance cover in the policy was not 10 times of the annual premium as mandated under law.

Conclusion – ULIP vs Mutual fund, what to choose?

I cannot shun ULIPs completely. Though I have a problem with its structure, still there are products and will also come in the future with low costs and which may suit the requirement of Investor. So, it is always wise to hear with both the ears and decide with Brain. But No Emotional Buying Please.

For now, it seems that the post-tax returns of mutual funds should be better than the ULIPs due to latter’s high-cost structure.

Liquidity challenges require investor to be confident in their cash flow position, so the regular premiums can be honoured timely without feeling the cash crunch.

Low flexibility demands that portfolio should not be overallocated in ULIPs, and one must have all kind of suitable investments into the profile.

With all these conditions and restrictions, my vote will go to Mutual funds. However, I am still open to ULIPs with Low-cost structure if I find it a suitable fit in my client’s portfolio looking at his/her cash flow situation.

What are your views on these 2 products? In ULIP vs Mutual fund which one would you prefer? Do share your views in the comments section.