Month: February 2021

Tick-tock, tick-tock — rushing to do your last-minute tax-savings before March 31. Two instruments always discussed during this time are equity-linked savings schemes (ELSS – tax-saving mutual funds) and unit-linked insurance plans (ULIPs – market-linked insurance plans). The Budget has put the spotlight on ULIPs with a key tax change. In this light, we re-visit the ELSS vs ULIP argument.

Construct

An ELSS invests at least 80 per cent of its assets in equity and equity-related instruments. Investments in an ELSS qualify for tax deductions under Section 80C of the Income Tax Act within the overall annual limit of ₹1.5 lakh. As a measure of popularity, ELSS, with 1.23 crore folios, is the largest equity fund category in the MF industry. The average investor account value, when it comes to ELSS, is ₹95,000.

On the other hand, ULIPs are a combination of insurance and investment offered by life insurers. ULIP premiums are also eligible for tax deduction under Section 80C. In FY20, ULIPs formed 18 per cent of the life insurance industry product mix, but constituted 44 per cent for the private sector. For top insurers, the average retail annual premium equivalent per ULIP was about ₹1.8 lakh in FY20, indicating their popularity among high-networth individuals (HNIs).

Insurance

ULIPs are marketed as a two-in-one product, but they are less of an insurance policy and more of an investment. If the maturity proceeds of a ULIP are to be tax-exempt under Section 10(10D), the insurance cover in the ULIP needs to be at least 10 times the annualised premium. This could be a relatively small life insurance cover for many as the cover should take into account your income and expenses as well as liabilities.

ELSS does not have any in-built insurance component. But fund houses such as ICICI Prud, Nippon India, ABSL and PGIM offer no-cost insurance cover (of up to ₹50 lakh) per eligible investor if you invest through a Systematic Investment Plan (SIP) for at least three years in the respective tax-saving fund. SIP insurance is free for ELSS investors. A few new-generation ULIPs refund the mortality charge if you stay put till maturity.

Taxation

At present, ELSS investments, like other equity fund investments, face 10 per cent long-term capital gains (LTCG) tax arising out of the sale of units if the LTCG exceeds ₹1 lakh in a financial year (gains up to January 31, 2018, being grandfathered).

Until now, there had been no capital gains tax for ULIP proceeds on maturity. A part of this tax arbitrage has been closed by the latest Budget, especially for high-income earners.

The Budget has proposed that ULIP maturity proceeds be taxed just like equity mutual funds if the annual premium is more than ₹2.5 lakh (implying a sum assured of about ₹25 lakh, going by the condition for exemption under Section 10(10D)) on new ULIPs signed on or after February 1, 2021. The tax, however, will not apply to sums received on the death of the insured.

A few grey areas arise here. One, while ULIPs with a premium of over ₹2.5 lakh will be taxed as equity funds, not all ULIPs are entirely linked to equities. ELSS schemes offer only equity portfolios, but ULIPs offer asset classes such as equity, debt, hybrid — portfolios comprising large-caps, mid-caps, balanced, income, bond, government securities, etc.

Two, now that there is no Section 10(10D) benefit for high- premium ULIPs, it remains to be seen how the premium versus sum-assured parameters change for policies which call for a premium of over ₹2.5 lakh.

Three, in mutual funds, ‘switching’ of investment in units within the same scheme from growth option to dividend option (or vice-versa), and from regular plan to direct plan (or vice-versa) is liable to capital gains tax.

However, switching of investments to/from investment plans to another within the same ULIP does not appear to be subject to capital gains tax, going by the Budget Memorandum.

Liquidity

Each investment in ELSS carries a lock-in of three years (each SIP is locked in for three years), which is quite low for equity investments.

One should invest with a greater time horizon of 5-7 years. Even if you don’t invest regularly, your existing ELSS investments are intact and earn market-linked return.

In the case of ULIPs, there is a five-year lock-in period. During this time, if you are unable to pay premiums upon expiry of the grace period, the policy is discontinued. The residual fund value, after deducting discontinuance fee, is put into the discontinued policy fund (gives 4 per cent pa) while any risk cover ceases to exist.

Investors in ULIPs can redeem the entire amount at the end of the five years even if the premium has been paid in instalments. In ELSS, only those units that have completed the three-year lock-in can be sold.

Costs

Regular plans of tax-saving mutual funds cost 1.6-2.5 per cent (total expense ratio) of the assets under management. Direct ELSS plans are cheaper. The 10-year lump-sum returns for regular ELSS plans range from 10 per cent to 18 per cent CAGR.

In ULIPs, if the policy term is 10 years or less, norms say the difference between the total return and post-cost return can’t be more than 3 per cent on maturity. If the policy term is over 10 years, the difference between the total return and post-cost return can’t be over 2.25 per cent on maturity. Based on just NAVs, the 10-year lump-sum returns for equity ULIPs range 6-17 per cent CAGR (pre-expenses).

Costs are coming down in new-generation ULIPs, with a few insurers removing premium allocation charges, refunding mortality charges, charging fund management charges on par with mutual funds, reducing/removing switching charges and premium allocation charges. Additionally, ULIPs are trying to sweeten returns with ‘loyalty additions’, ‘wealth boosters’, etc.

(This is a free article from the BusinessLine premium Portfolio segment. For more such content, please subscribe to The Hindu BusinessLine online.)