Should you choose an ELSS scheme or a ULIP scheme?

Many investors who want to save on tax tend to get confused between an ELSS scheme and a ULIP scheme. The only thing common between the two is that both are tax saving instruments and both offer tax exemptions under Section 80C of the Income Tax Act. Other than that there some key differences between a ULIP and an ELSS plan. Here are some of the key differences that investors need to know to take a rational decision.

Mutual funds versus insurance… 

Remember, an equity linked savings scheme (ELSS) is just like any other diversified equity scheme offered by mutual funds. The only difference is that an ELSS scheme comes with a 3-year lock in period. When you invest in ELSS, you get exemption under Section 80C of the income act. If you want to redeem your ELSS scheme before the 3 year lock-in period then you lose the entire tax exemptions claimed and it will be taxed as income in the hands of the investor in the year in which it is redeemed. An ELSS does not have any insurance component to it.

A Unit Linked Insurance Plan (ULIP) is a savings cum insurance plan. Apart from building your wealth over a period of time, a ULIP also gives you life insurance cover. The cost of the insurance tends to get loaded in the cost of the ULIP, which is discussed later. A ULIP is typically issued by insurance companies, while an ELSS is issued by mutual funds.

Costs of an ELSS and ULIP…

What investors need to understand clearly is the difference in the cost entailed in a ULIP as compared to an ELSS. An ELSS only has the normal costs like entry loads and the fund management charge that is debited to the ELSS. If you opt for a direct plan of an ELSS, then even the entry load is entirely exempted. This makes the ELSS substantially more cost efficient compared to the ULIP.

A ULIP, on the other hand, deducts the costs towards mortality charges, administrative expenses, insurer fees and fund management charges. As a result, ULIPs have a very high cost structure in the initial years. As a result, the ULIP takes a long time even when you are in the midst of a bull market. The cost structure of a ULIP is substantially higher as compared to ELSS and therefore tends to depress your effective return. The normal experience is that a ULIP takes at least 3-5 years under normal market conditions to break even and your profits will start only after that. In fact the loading in case of a ULIP can be as high as 60% in the first year and progressively goes down after that.

Transparency in an ELSS versus a ULIP…

One of the key differences that investors need to understand is that an ELSS is a lot more transparent as compared to the ULIP. In an ELSS, you can buy and sell at the NAV, the portfolio of the fund is disclosed on a monthly basis with its returns compared to the benchmark index. Additionally, the costs of a ULIP are also known transparently and the calculation of the NAV of an ELSS is fairly simple and transparent.

On the other hand, the NAV calculation of a ULIP is fairly more complicated and opaque. The justification of the loads in the initial years is not exactly visible to the investors. Even the ULIP statement that lays down the calculation of the NAV is quite opaque and it is difficult for any investor to easily grasp the returns that they are actually making on the ULIP.

Liquidity is another issue for comparison…

An ELSS is far more liquid as compared to a ULIP scheme. Of course, there is the 3 year lock-in on ELSS schemes. Once the lock-in period is completed, the ELSS can be redeemed on tap either online or by visiting the nearest mutual fund office in your city. ULIP, on the other hand, has a minimum lock-in of 5 years. But that is normally not sufficient to earn you an effective positive return after considering time value. It has been observed that investors need anywhere between 10-15 years to earn an effective return on ULIPs after considering the time value.

But ULIPs surely score on flexibility over ELSS…

This is one area where ULIPs score over ELSS. In an ELSS, the fund management is at the discretion of the fund manager. As an investor you have little say in deciding whether you want to be in debt or more in equity. That advantage is offered by ULIPs. In a ULIP you can choose whether you want your funds allocated in equity, debt or a mix of both. In fact, the flexibility goes to the extent of allowing you to switch from one scheme to another depending on the situation. That is surely one major advantage of ULIPs.

In conclusion, ELSS is a pure investment product while ULIPs are a mix of investment and insurance. If you get into ULIPs you must be prepared to wait for the long haul. The initial loading is too high to enable you to make returns in the short run. But as basic financial planning prudence teaches you, it is best to keep your investment and insurance decisions separate.

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