Budget 2021 brought about a big change in the ULIP landscape. For new ULIPs purchased on or after February 1, 2021 and with a premium amount of Rs 2.5 lakh per year or more, the maturity amount will now be taxable. Earlier, this maturity amount was tax-free.
Do note that the maturity amount on ULIPs with premium less than Rs 2.5 lakh a year or payout in case of death of the policyholder continues to remain tax-free.
As a result of this move, the ground is more even now. And ULIPs no longer offer the tax arbitrage that they used to till very recently. So, this move has no doubt brought in some parity between taxation of ULIPs and mutual funds – at least where premiums are high, a space that HNIs operated in.
This new change is bound to have an impact on how high networth individuals (or HNIs) used to look at ULIPs.
Taxing higher premiums
Because, first, it’s possible only for HNIs to pay very high annual premiums for such ULIPs. Second, due to the tax-free nature of their maturity amount, HNIs had recently got a liking for ULIPs after the reintroduction of long-term capital gains (LTCG) tax on equity investments in 2018. Earlier, gains on equities held for over a year were tax-free, but post Budget 2018, these were taxed at 10 percent for gains above Rs 1 lakh.
To avail this tax advantage, many HNIs used ULIPs as a backdoor to invest in equity and get tax exemption on their capital gains. But now, with the tax exemption gone, ULIPs are no longer that attractive from a tax perspective.
There was another advantage that ULIPs offered before this rule change. ULIPs are hybrid products that allow investors to divide their investments among multiple funds, including equity and debt schemes.
So a ULIP policyholder till now could switch between equity and debt funds without any tax implication on the generated capital gains. But this benefit wouldn’t be available anymore.
The government hasn’t clarified fully on how the taxation of gains would work in the case of intra-ULIP switches, i.e., when an investor switches from an equity to a debt fund or vice versa during tenure and before maturity. But seemingly, the taxability would differ depending on whether the ULIP fund qualifies as an equity-oriented fund or a non-equity (debt) oriented scheme.
As of now, for a fund to quality as equity-oriented fund, it needs to have a minimum of 65 percent of the total portfolio invested in equity. So long-term capital gains resulting from the sale of equity-oriented ULIP funds will be taxed at 10 percent above Rs 1 lakh while the short-term capital gains will be taxed at 15 percent. Short-term capital gains from debt-oriented ULIP funds will be taxed at the marginal tax rate. As for long-term capital gains, they will be taxed at 20 percent after indexation.
So, for now, there shall be no tax-free rebalancing for ULIP investors. At least for those whose annual premium exceeds Rs 2.5 lakh.
Note: It’s possible that in due course of time and as there are some doubts regarding this, the government may come out with a clarification around this aspect of taxation of various types of equity-oriented and debt-oriented ULIP funds.
What must HNIs do?
The best step is to keep things simple. And this is not just for HNIs, but for everyone.
Having plain and simple equity mutual funds for equity exposure is a better bet. If one is not satisfied with one equity fund’s performance, one can easily switch to another equity fund. But this isn’t exactly possible with ULIPs, as the investor is stuck with one company’s scheme for the entire tenure. Expenses of equity funds, too, are much lower than ULIP’s long list of charges such as those for premium allocation, mortality and policy administration.
So, with the tax arbitrage of ULIPs gone for good, it’s in the interest of all HNIs to rethink their investment strategy and look at other more suitable and transparent alternatives.