ELSS vs ULIPs: Which is better tax saving option?

Are ELSS funds attractive or ULIPs?

One of the popular debates that investors and advisors love to have; is about a better tax-saving instrument. Is it ELSS or is it the ULIPs offered by insurance companies? In a sense, both have an equity component and they can create wealth over the long run. Also, both are eligible for tax exemptions under Section 80C of the Income Tax Act. They offer tax benefits under Section 80C up to Rs1.50 lakhs per year. In the past, ULIPs have been subjected to mis-selling, but that has been largely controlled through better regulation. Then why is this debate on ELSS versus ULIPs gaining prominence once again.

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What triggered the ULIP versus ELSS debate?

One of the arguments in favour of ULIPs has started post 2018. You would be aware that in the Union Budget 2018, the government re-introduced capital gains on long-term capital gains tax. Obviously, any stock or equity fund held for more than one year is a long-term asset and subjected to long-term gains tax at 10% flat after the basic equity exemption of Rs1 lakh per year. Till April 2018, long-term gains on equity and equity funds were entirely tax-free. However, post-2018, the ULIPs continue to be tax-free when redeemed since insurance is still not subjected to capital gains. There have been protests by AMFI that ULIPs must be at par with ELSS as they are similar products, but we leave that aside. What we look at is why the ELSS is still a much better product than the ULIP for investors.

Verdict; ELSS can still beat ULIPs by a margin

When we look at the nuances of a ULIP and an ELSS fund, the conclusion is that the ELSS still beats the ULIP by a huge margin. There are 10 points of comparison which explains why ELSS still holds an edge over ULIPs. Let us now delve into the reasons for the same. 

1. ELSS still score over ULIPs on transparency. A good investment product is defined by its transparency with respect to loads, initial costs, and portfolio disclosures. ULIPs really do not cover themselves in glory on this front because the costs remain abstruse to most investors. The only thing they understand is that the loading in ULIPs is huge. ULIPs also carry a high implied loading due to the insurance cover factor.
    
2. Some investors and advisors do argue that the ULIPs combined the best of insurance and investment. From a financial planning perspective, combining insurance and investing is never a good idea as the one is about enhancing returns and the other is about risk and uncertainty. It is, therefore, a better idea to keep your insurance and investments separate. What you can actually do is to buy ELSS for tax saving and growth and buy a term policy separately for the risk and uncertainty cover.
    
3. How is combining an ELSS fund and a term risk cover a better option. There are 2 reasons. Firstly, both the ELSS and the term policy are eligible for Section 80C benefits, so there is nothing you lose out. Secondly, the cost of a term policy is much lesser, so you can get a much higher cover to cover life and even your liabilities. 
    
4. ELSS is subjected to LTCG tax while ULIPs are not. In the final analysis, the difference is not meaningful. In the case of ELSS, while, profits are taxable, losses can be used to write off and losses can also be carried forward for 8 years. Secondly, there is a base exemption of Rs1 lakh per annum on equity funds and you can plan your withdrawals. 
    
5. One of the big advantages of mutual funds is the flexibility that it offers. Remember that, in an ELSS only the capital gains are taxed and you can surmount that problem by opting for a systematic withdrawal plan (SWP). By opting for an exit route via SWPs, the tax outflow can be reduced substantially in ELSS and neutralize the ULIP benefits.
    
6. A more relevant question is; how much does the additional tax cost really impact the final returns? If you hold for a 3-year period, the impact is around 1%. As you cross 7 years of holding an ELSS, the  impact will be less than 50 basis points. When you are looking at creating a huge amount of compounded wealth over a longer time frame, 50 bps hardly makes a difference.
    
7. Both ULIPs and SIPs have a lock-in period. However, in the case of ULIPs, the lock-in period is 5 years while for ELSS the lock-in is just 3 years. In an ELSS, you effectively get the same benefit in a span 3 years, that you would get in 5 years in a ULIP investment.
    
8. This raises an interesting point of churn. Over a 15 year period, you can recycle ULIPs just for 3 tax benefits, while the ELSS provides 5 tax benefits. That is surely an edge.
    
9. ULIP generally become profitable like a mutual fund after 10 years only. Till then the upfront loads on ULIPs are too high; so, the LTCG advantage is just illusory for ULIPs. 
    
10. Did you know that an ELSS fund is more flexible and hence gels better with your financial plan. When you create a financial plan, you demarcate your insurance needs and your investment needs. Term policies are for insurance needs and ELSS is for investment needs.

Forget about LTCG tax changes. ELSS still holds its edge over ULIPs for sure!