The ULIP Paradox: Tax Perks Come with Unexpected Long-Term Trade-Offs
Unit-linked insurance plans (ULIPs) are bundled investment products wrapped in life insurance, offering tax advantages but facing structural limitations that can impact long-term returns. In 2021, the government brought ULIPs under the tax net to discourage their sale as investment-only products and create parity with mutual funds. Under current rules, maturity proceeds from high-value ULIPs with annual premiums of at least ₹2.5 lakh are taxed as capital gains at 12.5% after the first ₹1.25 lakh exemption. For lower-ticket ULIPs, maturity proceeds remain tax-exempt if the sum assured is at least 10 times the annual premium, while death proceeds stay tax-free regardless of size.
Tax Advantages of ULIPs Over Mutual Funds
Despite taxation, high-value ULIPs retain certain benefits compared to mutual funds. First, capital gains tax is a flat 12.5%, unaffected by debt exposure within the ULIP. Second, investors can switch between fund options within the same ULIP without incurring capital gains tax, a flexibility not available in mutual funds where redemptions trigger taxes based on fund type and holding period. This has led ULIPs to adopt a mutual fund-like approach, with new fund offers (NFOs) and diversified categories.
Naveen Goel, co-founder and CEO of PolicyX.com, notes, "The number of fund options has more than doubled, aligning with mutual fund growth. NFOs in ULIPs provide variety for different market situations." This tax-free switching allows investors to shift strategies, such as from aggressive to conservative or large-cap to small-cap, without tax leakages that can harm long-term returns.
High-value ULIP investors benefit from a single 12.5% capital gains tax after the ₹1.25 lakh exemption, unlike debt mutual fund investors who pay tax at slab rates for post-April 2023 purchases. Raju Shah, partner at RCSPH & Associates, explains, "ULIPs are long-term products, so short-term vs. long-term tax distinctions don't apply. The Finance Bill 2025 terms them as capital assets, taxing high-premium ULIPs at 12.5% for maturity benefits from April 2026." For other insurance-investment products, maturity proceeds are taxable at slab rates if annual premiums exceed ₹5 lakh and policies are issued after April 2023.
Ajay Sehgal, managing director at Allegiance Financial, adds, "Individuals in the maximum tax slab favor high-premium ULIPs for tax-free fund switching until withdrawal." Satishwar B., MD and CEO of Bandhan Life Insurance Ltd., emphasizes, "Long-term investors leverage low fund management charges and free switches to achieve objectives."
Structural Limitations and Hidden Costs
ULIPs come with transparent costs, including upfront policy allocation charges deducted from premiums and ongoing mortality and fund management costs from the corpus. However, these expenses can significantly erode returns. Devang Shah, 43, saw his ₹7 lakh ULIP investment grow by only ₹4.4 lakh since 2017, while mutual funds in similar themes performed better, highlighting how early costs impact gains.
Shilpa Arora, COO at Insurance Samadhan, states, "In ULIPs, 10-15% is lost in the first year excluding mortality premium, with 4-5% not invested in subsequent years due to charges." Deepali Sen, certified financial planner at Srujan Financial Services, warns, "ULIPs lose the most productive years to expenses, as compounding gains peak in the first five years." Fund management charges range from 0.5-1.25%, but additional fees for premium allocation, policy administration, mortality, and switching beyond free annual limits can meaningfully reduce returns.
Moreover, ULIPs offer minimal insurance coverage. Shah's life cover of ₹10 lakh was insufficient for his housing loan and family needs, illustrating how the product may not meet real insurance requirements.
Strict Lock-Ins and Sales Pitfalls
ULIPs enforce a five-year lock-in period, preventing surrender or withdrawal initially. Tarun Bahri, CEO of Policy Exchange, reports, "About 40% of investors seek to exit ULIPs, while 20% take loans against policies to fund premiums." Unscrupulous sales tactics, such as marketing ULIPs as fixed deposits to the elderly, can trap investors during emergencies.
The Reserve Bank of India's Financial Stability Report for December 2025 reveals that 37% of life insurance payouts in 2024-25 came from early exits, surrenders, and withdrawals, compared to 35% from maturities and 7.5% from death claims, indicating widespread dissatisfaction.
Financial Planners Recommend Separation
Despite ULIP advantages, experts advise keeping insurance and investments separate. Vivek Rege, founder and CEO of V R Wealth Advisors, argues, "It's better to separate due to expense ratios and inertia. ULIPs limit fund management style changes, so taxation shouldn't drive investment allocation—performance and flexibility should." Pure term life insurance combined with mutual funds often provides more value, avoiding the trade-offs of bundled products.
In summary, while ULIPs offer tax perks like 12.5% capital gains tax and tax-free switching, investors must weigh these against high costs, inadequate insurance, and rigid lock-ins to make informed long-term decisions.
