Why the Union Budget 2022 Must Iron Out the Tax Disparity between Mutual Funds and ULIPs

However, the Unit-Linked Insurance Plans (ULIPs) --which essentially is also an investment product--on the other hand, remained outside the purview of capital gains tax provided the policyholder derived at least 10X protection of the annual premium on the policy and held investments for at least 5 years. The withdrawal proceeds, irrespective of early surrender, partial withdrawals, and/or at maturity, enjoy an exemption under Section 10(10D) of the Income Tax Act, 1961, besides the fact that investments made into ULIPs are eligible for a deduction under Section 80C.

The Finance Act 2021 addressed this disparity to some extent by carrying out an amendment in Section 10(10D) and took away the favourable tax treatment, i.e. the exemption given to ULIPs if the annual premium exceeded Rs 2.5 lakh in the case of a ULIP issued on or after February 2021. Was that enough? Perhaps, not!

Also, the point is that the switch from one type of fund or plan under the ULIP is not considered as 'transfer' (so there is no capital gain tax on it). In contrast, in the case of a mutual fund, the inter-scheme switches and the change from dividend option to growth option or vice versa are considered as 'transfer' and subject to capital gain tax.

This differential tax treatment between two comparable investment avenues, equity mutual funds and ULIPs, creates a bias in favour of ULIPs (which are classified as insurance-cum-market linked investment products).

The question then is, should the investor in ULIP be incentivized more to buy a product that combines insurance and investments than an investor deploying money into equity mutual funds?

The Association of Mutual Funds in India (AMFI), in its proposals for Union Budget FY2022-23, has requested the government to bring ULIPs and equity mutual funds completely at par as regards their taxation status. Further, the mutual fund industry body has drawn the government's attention to a potential loss in revenue for the government due to tax arbitrage available to ULIPs. Now it remains to be seen whether the government irons out the disparity in taxation of ULIPs and treats them at par with equity mutual funds.

I am hopeful that the finance minister, Ms. Nirmala Sitharaman, will take a holistic view of the situation before discarding the suggestion given by AMFI. A few might cite the LIC IPO (Initial Public Offering) as a major reason why the government might remain reluctant to change any tax law governing investment-cum-insurance schemes. But that may not be an intelligent excuse! The life insurance sector in India collected Rs 91,007 crore of premium from 'market-linked policies' like ULIPs in FY21, of this, LIC's contribution is only 1.5%. Moreover, the premium on market-linked policies accounts for just 0.35% of LIC's total premium collection in FY21. In other words, LIC is primarily focused on traditional plans, and any potential change in the tax treatment for ULIPs won't make any significant difference to its business prospects.

If the government were to remove the tax disparity between ULIP and equity mutual funds, the private insurers would be the ones to be more affected than the state-owned LIC. That being said, the government must iron out tax disparity between ULIPs and equity mutual funds to create a level-playing field and not allow one product to have the edge over the other. This is essential given that the share of both insurance and mutual funds to India's GDP is relatively lower than the global averages even though it has improved in the recent past with the financialisation of savings.

Should you invest in ULIPs since they are tax-efficient against mutual funds -- at least for now?

At PersonalFN, we have always suggested our readers and subscribers not to comingle their insurance and investment needs by purchasing insurance-cum-investment plans. Keep the two separate in the financial planning exercise. When you are looking to indemnify the risk to your life, consider pure term insurance plans for the cost-to-benefit it offers, i.e. you can get better life insurance coverage for a reasonable insurance premium. Download PersonalFN's 'Your Definitive Guide to Buy Life Insurance' to get a holistic perspective about everything you should know when buying a life insurance policy.

When it comes to investing and addressing financial goals, mutual funds are one of the most potent and excellent cost-effective avenues for wealth creation. Many categories and sub-categories of mutual fund schemes have generated appealing returns over the long term. If you choose a mutual fund scheme wisely in accordance with your risk profile, investment objective, financial goal/s, the time horizon to achieve the goal/s, and strategize your mutual fund portfolio well, investing in mutual funds could prove rewarding for you.

Here's why ULIPs fail to impress me...

In its initial days, ULIP was a high-cost-moderate-return product that exposed investors to market-related risks, but its high-cost structure marred the returns. High commissions paid to insurance agents ate into the returns as well. Taking the cognizance of rampant mis-selling that happened in ULIPs, the Insurance Regulatory and Development Authority of India (IRDA) imposed caps on some expenses. Gradually the cost component of ULIPs became more competitive; but does that make ULIPs better against mutual funds? Not really.

Even now, insurance companies deduct various charges under multiple heads namely, mortality charge, premium allocation charge, policy administration charge, surrender charge, and fund switching charge beyond a few free-switches per policy year amongst others.

And barring a few ULIPs sold exclusively as online-no-broker-products by a few private-sector insurers; ULIPs still don't score high against mutual funds in terms of cost-effectiveness and performance.

Mutual funds as an investment avenue have most often helped them create wealth intelligently with various available choices. Below are some major advantages of investing in mutual funds.

I would like to reiterate, irrespective of whether the government irons out tax disparity between mutual funds and ULIPs, mutual funds are the way to go for long-term wealth creation. Having said that, structuring the mutual fund portfolio wisely is a prerequisite for making the most of your mutual fund investments.

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Happy Investing!

Warm Regards,
Rounaq Neroy
Editor, Daily Wealth Letter

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