ULIP vs Mutual Funds: ULIPs lose tax arbitrage (Budget 2021)

So after the new announcement in Budget 2021, that ULIPs will be taxed liked MFs if annual premium exceeds Rs 2.50 lakh and hence, ULIPs no longer offer the tax arbitrage that was pushed by ULIP sellers till now.

Just a reminder (and you can check full details here), that from February 2021 onwards, if you buy a new ULIP with an annual premium of more than Rs 2.5 lakh, then the maturity proceeds of the ULIP will not be tax-free like earlier and instead will be taxed in a manner similar to the mutual fund taxation.

Do note that only the gains on maturity amount of ULIPs arising from redeeming the units of ULIPs with a premium of or above Rs 2.5 lakh would be taxed. However, there will be no tax if exit is due to death of ULIP policyholder.

The budget endeavours make the taxation of money received from Unit Linked Insurance Policies (ULIP) of life insurance companies on par with equity mutual funds from a taxation perspective.

So why was this move made by the government?

Here is a short explainer.

ULIPs started gaining prominence again after the reintroduction of long term capital gains tax on investments in equity and equity-linked instruments in Budget 2018. Since the 10% LTCG tax on equity was reintroduced for equity in 2018 (and which earlier used to enjoy tax-free status), there was a growing and I would say a fair demand from the mutual fund industry and investors to bring in parity of tax treatment with ULIPs.

ULIPs are hybrid products that combine insurance and investment in equity and debt. But they have primarily been sold as equity investments products over the years and with equity gains becoming taxed in 2018, ULIPs had an undue advantage in the form of exemption under Section 10(10D). Read more about life insurance maturity taxation in India.

Now HNIs in general got attracted to this tax-free status over the last few years and had started investing in equity via the ULIP route. That is, many wealthy investors have invested in ULIPs due to this tax arbitrage as they were exempted from paying any capital gains tax. So with the tax exemption now gone, ULIPs would no longer be as attractive for HNIs as they used to be.

And given the opaque nature of ULIPs in general, the high net worth investors who invested in equity via ULIPs will now be wise to re-evaluate their choices and opt for more transparent alternatives like equity mutual funds.

Another aspect is that this change will curb the mis-selling of ULIPs to some extent. ULIPs have been aggressively sold (or pushed) on the premise of combining investment with insurance, ‘claimed’ equity-like returns and tax-free status (till now). But very few ULIP agents or banks (which sell and push ULIPs a lot) were honest enough to explain the full details and actual return profile of ULIPs. So now with no tax-free maturity benefit, at least one part of the sales pitch is correctly handled.

Related reading: Don’t take financial advice from your bank

I have long maintained that we should not mix insurance with investments. Something that products like ULIP and traditional insurance plans like endowment and moneyback policies do. And given how ULIPs have been mis-sold in recent years to unsuspecting customers, I don’t like this opaque, expensive and poorly performing investment product which is often disguised as insurance to take advantage of the tax advantage (which has now been removed in Budget 2021). To be honest, ULIPs are useless as insurance products as if you go to buy an adequate amount of life insurance via ULIP, then you would end up paying lakhs of rupees in annual premium!

I maintain my stance that investing in Unit Linked Insurance Plans (ULIPs) is not worthwhile. It’s best to handle your life insurance needs via simple term insurance plans and long term investments via equity funds, debt funds, EPF, VPF, PPF, etc.

With the doing away of the tax-free nature of ULIP maturity amount, Ulips are bound to lose a bit of sheen, and rightly so. This will now bring mutual funds on par with ULIPs as long-term investment products again and will be a positive for mutual funds in that respect.