Budget 2021 came as a shock to insurers who sold ULIPs. Their tax-status was changed from tax-free to taxable as capital gains (like mutual funds). In this article we discuss a question posed by a reader: Should ULIPs be avoided due to change tax rule in budget 2021?
When equity mutual funds became taxable in Feb 2018, ULIP manufacturers rejoiced. Bet Feb 2018 to Feb 2021, ULIPS were the only market-linked tax-free product and this was used as a prime selling point. We had pointed out even then: Do not buy ULIPs because equity mutual fund LTCG will be taxed!
MF manufacturers have been highlighting this disparity between ULIPs and mutual funds to the finance ministry and they have finally listened.
What is a ULIP? A ULIP is a combination of a life insurance cover and a mutual fund managed by the life insurance. Each year the cost of the life insurance cover will be deducted by removing ULIP fund units from your account. Hence unit-linked policy. As you age, the cost of life insurance increases (unlike term insurance). At the same time, as the value of your ULIP fund increases, the cost also decreases. Once the fund value exceeds the sum insured, the unit reduction will stop, but this takes several years. Read more: How ULIP Charges Reduce Returns!
In addition, there is a fund management charge taken from the fund value. Currently, this charge is well below that of regular mutual funds and a touch below or equal to direct mutual funds. There may be other charges like premium allocation and policy administration as a percentage of the annual premium. Something that takes this long to explain should be avoided!!
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ULIPS vs Mutual funds: Which is better?
Discussions on ULIPS vs mutual funds are often only about costs. This is flawed because investors are missing the most crucial difference between ULIPs and mutual funds. The good news is the tax disparity is now full removed. The cost disparity has also been removed to a large extent (except for the unit-linked nature of the life cover)
Let assume that both mutual funds and ULIPs have the same expenses (this is not true as mfs are less expensive when combined with a term plan, but please play along).
Some questions for mutual fund investors? Have you ever worried about the star rating of your fund? Changed funds when it lost stars? Changed funds when returns were poor?
Do you see ULIP investors talk about star ratings (it is available at Morningstar). Do you see them exit a ULIP after few years and buy a new one? Relatively speaking, the answer is a practical ‘no’.
If your ULIP does not perform well (many ULIP buyers don’t look!) then you are trapped. Sure, sure you can exit and buy a new ULIP at an older age, higher premium and higher (repeated) cost. Ulips bring forth the true meaning of “never combine insurance with investing”.
You do not get married to your fund managers! If they are not performing, chuck them and find another one. while you do this, you do not jeopardize your life cover if you separated insurance and investing. That is taken care of by a term plan with constant premium which seems smaller and smaller due to inflation and a higher salary.
This is why mutual funds + term insurance is so much more superior to ULIPs even though the gains (if any) are taxed similarly. Forget the costs! Forget the taxes! The flexibility to move in and out as we please is essential for risk management in equity.
The fund manager risk is ULIPs is the real risk! In mutual funds, I can change fund managers at any point or shift to index fund at will.
If you value a tighter control on your portfolio and flexibility, then this ULIP tax is of no consequence to your plans: ULIPs should have been avoided before Feb 1st 2020 and at least should be avoided after.
Stay away from ULIPs, not because they are now taxed, not because they are expensive, but because you could get stuck with a terrible fund. What if I invest in multiple ULIPS? Sure, a scattergun approach will get your somewhere, but who knows how far that would be from your target?
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