ULIP vs. mutual funds - Understanding the difference

If you want to increase your wealth, one of the most popular options available to you is mutual funds. However, with so many types of mutual fund schemes in the market, you may be wondering which one is more suitable for you. And like many investors, you may be looking for an option that gives you an opportunity to increase your wealth while also helping you secure your financial future.

Enter Unit-linked Insurance Plans (ULIP). Both ULIP and mutual funds are great investment options for different types of investors. Let’s look at them one by one before entering the ULIP vs. mutual fund debate and finding which one is more suitable for you.

Table of contents

1. What are ULIPs?
2. What is a mutual fund?
3. Difference between ULIP and mutual fund: key comparisons
4. Taxation on ULIPs
5. Taxation on mutual funds
6. Charges and fees in ULIP
7. Lock-in period explained: ULIPs vs mutual funds
8. Fund switching in ULIPs vs mutual funds
9. Who should invest in ULIPs and who should choose mutual funds?
10. Factors to consider before choosing between ULIP and mutual fund

What are ULIPs?

A ULIP, short for Unit-linked Insurance Plan, is an investment plan that offers the combination of insurance and investment in equity, debt, or hybrid (equity and debt) instruments. A part of the premium pays for the life insurance cover and the rest is invested into equity, debt, or hybrid investment instruments for wealth creation.

What is a mutual fund?

A mutual fund is a type of investment scheme where an Asset Management Company (AMC) pools money from many investors to invest in equity or debt securities to create wealth. Most mutual funds have one or more fund managers assigned to manage the funds and to buy and sell securities to enhance the return potential for the investor based on the objectives of the mutual fund.

Difference between ULIP and mutual fund: key comparisons

Many investors like to carry out a little ULIP vs. mutual fund comparative exercise to find out which one is more suitable for them.

Let’s see the similarities first – both mutual funds and ULIPs offer investors the opportunity to create wealth. But the similarities end there.

Moving on, here are 5 key differences between ULIPs and mutual funds:

1. Investment objective

A mutual fund offers the opportunity to create wealth as it is a purely investment product whereas a ULIP is an insurance and investment product packed into one. It is important to note here that, for all practical purposes, ULIP is considered a primarily insurance product that offers the added advantage of investing in the market for wealth creation.

2. Lock-in period

• Being an insurance product at heart, all ULIPs have a mandatory lock-in period of at least 5 years. In contrast, the lock-in period for mutual funds depends on the type of scheme chosen by the investor.
• Close-ended mutual fund: The investor can only subscribe during the New Fund Offer (NFO) and wait until the lock-in period is over to redeem the investment in a close-ended fund.
• Open-ended mutual fund: The investors can redeem the investment at any time if they have invested in an open-ended scheme, subject to exit load.
• Equity-linked saving schemes (ELSS): In mutual fund schemes, it is only for Equity-linked Saving Schemes (ELSS) that a 3-year lock-in period is enforced. The investor can redeem their investment after 3 years.

3. Taxation

This is one of the important points that helps investors decide which one of the ULIP and mutual fund schemes is a suitable investment product for them.

Taxation on ULIPs

Investments in ULIP offer tax benefits under Section 10DD, 80C and 80CCC of the Income Tax Act. Let’s understand them in detail.

Tax Benefit on ULIP Premium: Investors can claim a total deduction of Rs. 1.5 lakh per annum on the premium paid towards ULIP subject to conditions under Section 80C and Section 80CCC of the Income Tax Act. For ULIPs issued after 1st April 2012, they are only eligible for the deduction if the premium amount is less than 10% of the death sum assured chosen for the plan. The deduction is capped at 10% of death sum assured for higher premium amounts.

Tax Benefits on Payout of Life Cover to Nominee: In the case of death of the policyholder, the life cover amount paid to the nominee is exempt from tax.

Capital gains from ULIP plans are taxed under the Short-term Capital Gains (STCG) category at 20% if the period of holding is less than or equal to 12 months. The capital gains are taxed under the Long-term Capital Gains (LTCG) category at 12.5% on gains above Rs. 1.25 lakh if the period of holding is more than 12 months.

Taxation on mutual funds

Investors can claim a tax deduction on investments made towards ELSS under Section 80C of the Income Tax Act. There are no tax deduction benefits on any other kind of mutual fund schemes. The capital gains from mutual fund investments are taxed based on whether they are debt or equity funds and how long they are held by the investor.

4. Risk level

Being primarily an insurance product, a ULIP offers risk cover and financial stability to the family in case of the sudden demise of the policyholder. Mutual funds offer no risk cover to the investor or their family. However, an important thing to note here is that both ULIP and mutual funds invest in the market and the returns depend on the market movement.

5. Return on investment

ULIPs offer a life cover because of the insurance component being built into the investment. The actual returns depend on the performance of the investment in equity and debt securities. The returns from mutual fund investments also depend on the performance of the investment in prevailing market conditions.

Read Also : ELSS vs ULIP: Key difference and which is a better investment option

Charges and fees in ULIP

ULIPs may involve multiple charges, including:

• Premium allocation charge: This is deducted upfront from the premium before investment.
• Mortality charge: This covers the cost of life insurance and depends on factors such as age, sum assured, and policy tenure.
• Fund management charge: This is an annual fee charged for managing investments. IRDAI has capped FMC at 1.35% per annum of fund value.
• Policy administration charge: A charge towards policy servicing and administration, which may be deducted monthly or annually, as per policy terms.
• Surrender/discontinuance charge: If the policy is discontinued during the lock-in period (currently five years), a discontinuance charge may apply. IRDAI has capped this charge, and it typically reduces over time and becomes nil after the lock-in period.

Lock-in period explained: ULIPs vs mutual funds

The lock-in period is the mandatory minimum holding duration before you can fully redeem or surrender your investment without penalties. It helps promote long-term discipline but may limit liquidity during emergencies.​

Fund switching in ULIPs vs mutual funds

Who should invest in ULIPs and who should choose mutual funds?

Factors to consider before choosing between ULIP and mutual fund

Here are factors you may want to consider before making your choice:

• Financial goals: ULIPs combine life insurance with an investment component, while mutual funds are primarily designed for investment and potential wealth creation. Mutual funds may be preferred by investors seeking a pure investment product.
• Liquidity needs: Mutual funds generally offer higher liquidity, allowing investors to redeem units with relative ease. ULIPs, on the other hand, come with a five-year lock-in, which encourages long-term discipline but limits access to funds in the early years.
• Cost impact: ULIPs may involve multiple charges, whereas mutual funds typically have a single expense ratio. Comparing the overall cost structure can help assess the impact on long-term returns.
• Risk appetite: Both ULIPs and mutual funds are market-linked and carry investment risk. In ULIPs, a portion of the premium goes towards life cover, which can influence the effective investment exposure.
• Tax planning: ULIPs may offer tax benefits under Section 80C of the Income Tax Act, 1961, and tax exemption on maturity, but there are certain applicable conditions such as premium limits. Mutual funds follow capital gains taxation rules, with ELSS funds offering Section 80C benefits.

Read Also : Investment: Types And Importance

Conclusion

In conclusion, there is no clear winner when it comes to the ULIP vs mutual fund debate. Both ULIP and mutual funds have their pros and cons. You can choose one or both depending on your investment portfolio. We recommend that you discuss it with your financial advisor before making any investment decisions.

FAQs:

What is the primary difference between ULIPs and mutual funds?

ULIPs (Unit Linked Insurance Plans) combine insurance and investment, while mutual funds solely focus on investment, providing distinct financial objectives.

Which option is more suitable for long-term wealth creation?

Mutual funds are often preferred for pure investment purposes, offering more flexibility and potentially lower costs.

Is it good to invest in ULIP?

ULIPs can be a suitable option for individuals seeking both life insurance coverage and investment growth potential. They provide investment flexibility, tax benefits, and suit long-term horizons but involve various charges and market risks. Assess financial goals, risk appetite, and fees carefully, and consult a financial advisor before deciding on ULIPs.

What are the tax benefits of ULIP?

Taxation on ULIPs provides benefits under Sections 80C, 80CCC, and 10(10D) of the Income Tax Act. Premiums up to Rs 1.5 lakh annually are deductible if conditions are met. Death payouts are tax-free. Capital gains are taxed at 15% for short-term (≤12 months) and 10% for long-term (>12 months, above Rs 1 lakh).

Which is a more flexible investment – ULIP vs mutual fund?

Mutual funds offer more flexibility than ULIPs in fund selection, investment strategies, and liquidity. They provide diverse options, easy scheme switching, and higher accessibility. ULIPs, while less flexible, combine life insurance with investment benefits, appealing to those seeking dual-purpose financial solutions.

What is the return of ULIP in 5 years?

ULIP returns over five years vary based on fund performance, market conditions, charges, and investment strategies. Equity funds offer higher growth but involve more risk. Returns are not guaranteed and depend on underlying investments. Use ULIP calculators or consult financial advisors to estimate returns and align them with your goals and risk tolerance.

Is ULIP tax free after 5 years?

ULIP maturity proceeds are not automatically tax-free after 5 years. To qualify under Section 10(10D), the life cover must be at least 10 times the annual premium throughout the policy term. The 5-year lock-in restricts withdrawals but doesn’t ensure tax exemptions.