ULIP vs Mutual Fund: Which One is Better for Long-Term Investment?  

It can be quite difficult to make a choice between mutual funds and unit linked insurance plans (ULIPs) to build your wealth in the long-term. Although they both have rewards connected to the market, their functions are distinct. ULIPs combine life insurance and investments, whereas mutual funds solely focus on building wealth. 

Let’s compare the returns, the flexibility they offer, the tax benefits they come with, and which is more suitable for who. This comparison is going to help you in picking the most suitable option for your long-term financial goals, regardless of whether you place a higher priority on insurance coverage or larger returns. 

What is ULIP and How Does It Work? 

Since its founding, ULIPs have advanced significantly. The Unit Trust of India (UTI) launched the first ULIP in 1971, followed by the Life Insurance Corporation (LIC) in 1989. With ULIPs, you can reach both your investment and insurance goals with a single move. It also helps you to profit from the stock market, debt funds, or both, depending on the situation. 

A ULIP is a special kind of investment tool that combines life insurance coverage and wealth accumulation where investors can pay the insurance company a lump sum payment or regular premiums on a monthly, quarterly, or annual basis. 

First, your premium is broken down and billed where a part of it covers life insurance and the rest gets invested in the funds that you choose such as equity, debt, or hybrid, all managed by professionals. 

Next, your investment grows. Your money buys units whose net asset value (NAV) fluctuates based on the market trends, more like mutual funds. 

Lastly, you receive maturity benefits. You get the cumulative fund value (units × current NAV) at the end of the policy period. Beneficiaries will receive the final fund value, or the promised sum, whichever is greater, in the event of the policyholder’s death. 

What is a Mutual Fund and How Does It Work? 

Mutual funds are the investments that add up the capital of investors and use it to buy a number of financial instruments, such as stocks, bonds, government securities, gold, etc. Investment managers, or fund managers oversee mutual fund investments. These professionals buy and sell the securities on behalf of you. The performance of the investment portfolio regulates the fund’s performance. The fund managers invest a noteworthy amount of time in market research and stock selection to get here. 

Think of mutual funds like a ready-made investment basket in which your money rises in value along with that of other investors. This is how they work for you: 

1. Purchase units at NAV: Buying units in a mutual fund is determined by the NAV of the fund on that day. Consider NAV as the fund’s price per unit, which is determined every day after all its assets and liabilities have been taken into consideration. 

2. Expert fund management: A fund manager receives your money after it has been combined with that of other investors. They spread it throughout stocks (for expansion), debt and bonds (for stability), and other tools like arbitrage or gold. This is done to balance risk and generate higher profits. 

3. Earning profits: You can earn profits from mutual funds in two main ways: through capital appreciation, where the NAV (Net Asset Value) increases as the value of the fund’s investments grows, allowing you to sell your units later at a higher price; and through dividends or interest income, where certain funds distribute earnings from equities or bonds. These payouts can either be reinvested to buy more units or taken as cash, depending on your chosen option. 

4. Redeem your investment: You can redeem your units anytime and you will get the current NAV value per unit. 

5. Compounding power: You can boost your wealth by reinvesting the dividends or by staying invested for many years. For example, at 12% returns, a ₹10,000/month SIP can grow to ₹45+ lakhs in about 15 years. 

Key Differences Between ULIP and Mutual Funds 

Pros and cons of ULIPs and MFs 

Analysing the pros and cons of each option is an easy way to break them down to the basics and understand what works for you. 

Advantages and Disadvantages of ULIPs 

ULIPs offer a dual benefit of insurance as well as investments in one. They make your investing habits more disciplined with the regular savings. They are also highly transparent due to the stringent regulations. They encourage building wealth over the long term with their five-year lock-in period. 

However, you also need to consider some disadvantages. They come with higher charges like policy administration, premium charges and mortality charges. Some might find that the five-year lock-in period restricts liquidity. It is often seen that their dual nature leads to neither of the components being optimized to their fullest. They also sometimes offer fewer investment options as compared to mutual funds. 

Advantages and Disadvantages of Mutual Funds 

Mutual funds are quite flexible, since they have no lock-in period, except for ELSS (equity-linked savings scheme) which has a three-year lock-in. They are also more liquid; you can easily redeem them whenever you want. They have lower expense ratios than ULIPs, making them cost-effective. They highly help with diversification because they offer a wide range of schemes across asset classes. 

However, they lack an insurance component, coming with the need to plan for insurance separately. Frequently switching between mutual funds can impact your returns. Lastly, it has been observed that mutual funds need more active management from the investors. 

The ULIP yields comparatively lower profits than mutual funds. The rationale is because ULIPs guarantee a certain amount regardless of whether the investment plan generates profits. In contrast, the returns from mutual funds are affected by market risk. While debt mutual funds have slightly lower returns, equity mutual funds are likely to yield larger returns.  

Which is Better for Long-Term Wealth Creation?  

Your financial goals, risk tolerance levels, and financial expertise in the field all play a significant role in deciding between the two. A ULIP could be a smart choice if you want both investing and insurance, but mutual funds are typically a better choice if you only want to grow wealth because they offer a middle ground with lower risk and expert management. You can balance your risk and returns by spreading your assets over multiple options, which will put you on the correct track for long-term wealth growth. 

ULIP vs Mutual Fund – Tax Benefits  

Under Section 80C of the Income Tax Act, 1961, ULIP investments are eligible for tax deductions, meaning that you can claim up to ₹1.5 lakh per year. In contrast, mutual funds only provide a tax deduction for ELSS investments. There will be no tax deductions for investing in any other mutual fund scheme, and redemptions will be taxed according to your relevant tax bracket in case of debt mutual funds and as per capital gains tax in case of equity-oriented funds. Other mutual fund options don’t offer any direct tax advantages, making the difference between ULIPs and mutual funds quite noteworthy, at least from the taxation perspective. 

Taxation on ULIPs 

As per the Finance Act, 2021, amendments to Section 10(10D) have changed the taxability of ULIP maturity proceeds for policies issued on or after February 1, 2021. Under the new rules, if the premium paid for a ULIP exceeds ₹2.5 lakh in any year during the policy term, or if multiple ULIPs are held and their combined annual premiums exceed ₹2.5 lakh, the maturity proceeds (including any bonus) will no longer be tax-exempt. Instead, they will be taxed as long-term capital gains (LTCG) at a rate of 12.5%, similar to equity-oriented mutual funds. However, if the maturity proceeds are received due to the death of the policyholder, they will remain fully tax-exempt. 

Conclusion 

Mutual funds generally outdo ULIPs for creating long-term wealth because they offer higher returns, more flexibility, and they are cheaper. However, by combining investment with life insurance coverage, ULIPs have a value that makes them appropriate for investors looking for all round safety. In the end, your decision between insurance-backed investments like ULIPs and pure wealth building instruments like mutual funds depends on your priorities and goals for the future. Before you make a choice, think about your tax objectives, liquidity requirements, and risk tolerance.  

FAQs 

Which is safer – ULIP or Mutual Fund? 

Depending on your investment goals, risk tolerance, and time horizon, ULIP or mutual funds may be a good choice. Mutual funds only let you build money; ULIPs offer both investment and life insurance coverage at the same time. 

Can I switch funds in ULIP like mutual funds? 

 You can switch between funds in ULIPs without having to redeem any of them. Therefore, ULIPs are exempt from capital gains while switching funds unlike, mutual funds. 

Are ULIPs tax-free on maturity? 

ULIP maturity proceeds are taxable as LTCG at 12.5% if annual premium exceeds ₹2.5 lakh (single or combined policies), for plans issued on or after Feb 1, 2021. Proceeds remain tax-free in case of the policyholder’s death. 

Do mutual funds give better returns than ULIPs?

Mutual funds provide great liquidity, flexibility, and maybe higher returns. ULIPs offer tax efficiency, the flexibility to switch funds, and the combined advantages of investment and insurance. Except for tax-saving funds, mutual funds have no lock-in period and offer superior long-term returns.

What are the charges involved in ULIP and mutual funds?

ULIP have charges such as premium allocation charge, fund management fee, mortality charge, and surrender charges. Mutual funds have expense ratios, exit load, and no insurance costs.