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For a very long time, banks and other financial institutions have been coming up with innovative ways for you to invest your capital with them. ULIPs and ELSSs are just two other ways to do so.
In this article, we’re going to explore both these financial products, delve into the core of what they are, and understand their risks so you can make the best possible decision with your money.
Understanding ULIPs
Unit Linked Insurance Plans (ULIPs) are a unique financial instrument that mixes insurance coverage and equity investments into one. When investing in ULIPs, you pay a regular premium to the financial institution.
Now, the institution allocates a portion of your premium towards a life insurance benefit. The remaining premium is then invested in your chosen fund options, typically a mix of equity and debt instruments.
This investment component allows your money to grow over time. Some instruments like these can also have tax-benefit clauses.
ULIPs are good investments for risk-averse individuals seeking a balanced approach towards the markets. The insurance component acts as a safety net, while the investment portion offers the possibility of market-linked returns.
Understand, however, that the part of your premium that goes onwards your insurance could instead be invested in the market. These would generate additional returns for your capital, but also increase your risk significantly.
Here are some characteristics of ULIPs:
- Hybrid product: Blends insurance and investment.
- Moderate risk: Offers a safety net with potential for growth.
- Long-term focus: Ideally suited for long-term goals (10+ years) due to lock-in period and market cycles.
- Lower liquidity: There is also usually a lock-in period (typically 5 years) and surrender charges.
- Higher costs: Expense ratios can be higher due to insurance components.
- Tax benefits: Premiums paid towards ULIPs qualify for tax deduction under Section 80C of the Income Tax Act, up to a limit of Rs. 1.5 lakh per year. Additionally, maturity proceeds from ULIPs are tax-free if the policy term is at least 5 years and the annual premium does not exceed 10% of the sum assured.
Understanding ELSSs
Equity Linked Saving Schemes (ELSS) are a type of mutual fund that invests solely in stocks of companies across various sectors. They track the returns of the market, but are mostly actively-managed, which means that you could both underperform or over-perform the market depending on how good your manager is.
ELSS are ideal for investors with a higher risk tolerance and a long-term investment horizon (ideally 5+ years). The 3-year lock-in period for ELSS encourages staying invested in the market, which is said to be a good investing strategy. It’s like they say, “Time in the market beats timing the market.”
Here are some key characteristics of ELSSs:
- Pure investment: Focused solely on equity investments.
- Higher risk: Carries inherent market volatility, but with the potential for high returns.
- Long-term focus: Benefits from a long-term investment horizon to mitigate short-term volatility.
- Greater liquidity: Offers more flexibility after the 3-year lock-in period for partial or full redemption.
- Lower costs: Typically boasts lower expense ratios compared to ULIPs.
- Tax benefits: Investments qualify for tax deduction under Section 80C, with long-term capital gains exceeding Rs. 1 lakh taxed at a concessional rate.
Striking the correct balance between the two
Now that you understand the basic differences between the two securities, here are some things you need to consider when deciding which one to invest in:
Your risk tolerance
If you’re a risk-averse investor and are seeking to balance growth with stability, the obvious choice is some combination of ULIPs with bonds and other low-risk debt instruments. However, if you’re a little more comfortable with market fluctuations and want to aim for higher returns, ELSSs are a good bet.
How much time do you have?
The extended lock-in period of ULIPs requires a longer investment horizon to benefit from market cycles. ELSS, with its shorter lock-in, offers more flexibility but also more risk. If you’re young and can afford to take more risks with your savings, go for equities instead of insurance.
Costs
Both of these investment instruments have to be managed – either by a bank or another similar financial institution. ELSSs usually have lesser costs to you compared to ULIPs because there are no insurance charges you have to pay for. This means higher returns in the long term.
Frequently Asked Questions
ELSSs, with their focus on equity, have historically offered better returns compared to ULIPs. Understand, however, that this also comes with a higher risk.
Yes! Both ULIPs and ELSS qualify for tax deductions under Section 80C of the Income Tax Act. Additionally, ELSS offers tax benefits on long-term capital gains.
ELSS provides greater flexibility. After 3 years, you can redeem your investment partially or fully. ULIPs have a longer lock-in period (typically 5 years) and surrender charges before the policy term ends, making them less accessible in the short term.
This is a stability feature for most investors. People who already invest in life insurance and equities prefer to do this through ULIPs for a marginally lesser cost, less paperwork, and easier management over time.
While you cannot directly switch between ULIPs and ELSS, some ULIPs offer rider options that allow you to increase the investment portion over time. However, remember, switching strategies might have cost implications.