It is Union Budget time, and time to discuss taxation aspects, among other things. Let us discuss the tax treatment differential between investments in mutual funds and ULIPs. Till the Finance Act of 2021, it was open sesame, from the tax perspective, in favour of ULIPs. There is tax benefit under section 80C and maturity proceeds are tax free under section 10(10D). There are conditions under section 10(10D), that the sum assured in a life insurance policy is at least 10 times the annual premium and can be withdrawn after a lock-in of 5 years. Nonetheless, you get the proceeds tax free.
In the Union Budget previous year, presented on 1 February 2021, a new regulation came that in ULIPs purchased since that day, if the premium is more than Rs 2.5 lakh per investor per financial year, proceeds would be taxable. This regulation has reduced the disparity to a certain extent. That is, for high value ULIPs, proceeds are taxable at par with mutual funds.
However, it is not a level playing field. For ULIPs of premium within Rs 2.5 lakh per financial year, proceeds are tax-free. From a practical perspective, what are ULIPs? These are investment products with a wrapping of insurance coverage. If the argument is to say that the tax benefit is an incentive for purchase of insurance coverage, that can be achieved through term insurance as well.
There are certain advantages of mutual funds as investment vehicles over ULIPs. Flexibility is one big advantage. Whenever you want to exit, either due to cash flow requirements or allocation changes or performance issues, you can do it seamlessly in mutual funds. Some funds may have exit load for some period of time, but most funds do not have this clause, and beyond the exit load period there is no load. On the expenses charged, there is transparency: expenses are declared on a daily basis on the respective websites of mutual funds. The total expense ratio (TER) charged by mutual funds to a fund (technically called scheme) includes everything e.g. out-of-pocket expenses, distribution commission for regular plan, margin for the AMC, etc. As the AUM size of a MF Scheme increases, TER comes down gradually. Transparency on portfolio disclosure and fund management strategy is also better in MFs.
However, from a taxation perspective, it is not a level playing field. Section 80C benefit is available only in one category of funds from MFs i.e. Equity Linked Savings Schemes (ELSS). Though certain ticket size of ULIP investments have been made taxable, entire non-ULIP traditional policies are tax-free investment income. In a way, the system is giving the message that it is encouraged that the investor should come through the ULIP route.
If the thought process of the regulators is to incentivize and spread the concept of insurance coverage for the benefit of families, that can be achieved through the MF route as well. A new rule can be introduced that for MF investments, up to a certain age bracket, the investor can purchase term insurance upto a certain coverage or premium amount in proportion to the MF investments. The requirement may be similar to that of section 10(10D), that the coverage should be minimum 10 times the investment quantum in MF being put up for tax exemption. As a package i.e. MF investment plus term insurance coverage, it can be made eligible for tax exemption on maturity or withdrawal. A certain lock-in of the MF investments that have been put up for tax exemption, e.g. 3 years or 5 years, may be prescribed.
What would be the advantage of this move? The culture of savings and investments would be propagated, not just through the ULIP route, but the more pervasive MF route as well. Insurance penetration among the insurable population would be incentivized, which would spread a desirable habit. Investors would benefit from the better transparency of portfolio, fund management policies and expense disclosure of MFs. Investors would benefit from flexibility as well; though we have discussed the argument for lock-in for the MF investments put up for tax exemption, presumably, the lock-in period would be less than the usual tenure for ULIP products.
Spread of the MF industry requires support from the system, not just in the form of robust regulation by SEBI, but other incentives as well. The Sumit Bose Committee had pointed out that there is a disproportionate incentive structure prevailing in the life insurance sector. Hence from the perspective of the overall investing population, this move is worth being considered in the forthcoming Union Budget.
(The writer is a corporate trainer and author.)