How NPS can be used to save tax and create a retirement corpus?

The National Pension System (NPS) is a recent addition to the tax saving lexicon. Unlike other insurance policies and provident funds that have existed for a long time, the NPS is a recent addition with a lot of unique features and additional dedicated tax benefits. Apart from the tax benefits, it also gives investors in NPS the choice to decide whether they want to invest predominantly in debt or equity or a mix of both. This additional choice is a major advantage of this scheme as it enables the person according to her age to select the investment plan that is most suitable.

What is the NPS all about…?

The NPS scheme was launched six years ago on the lines of 401-K in the US. The problem in India is that long term funds like pension funds were forced to invest in debt which offered lower returns. Under the NPS, the individual could make a choice whether he wanted a predominance of equity, corporate debt or government debt. The investor can also opt for an “Auto-Choice” in which case the fund will automatically allocate money based on a life cycle matrix. Initially, there were problems that the intermediaries like banks were not adequately incentivized to market these products and hence they did not take off. In the last budget, the government has introduced a special Income Tax exemption under Section 80CCD (1B), which has an upper limit of Rs.50,000/- per financial year per person. This is in addition to the normal benefits under Section 80CCD(1) that are available on other similar schemes. This additional tax benefit on NPS makes it more attractive as a tax saving option as well as a long term retirement planning mechanism.

Understanding Tier-I and Tier-II in case of NPS…

NPS offers investors two kinds of accounts. There is a compulsory Tier-I account and a voluntary Tier-II account. Having an active Tier-I account is a necessary pre-condition to open a Tier-II account for an individual. There are restrictions on withdrawal from a Tier-I account as a part of the corpus at the end of the tenure of the NPS will be used to buy an annuity which will assure regular pension payout to the NPS holder. There are no such restrictions on the Tier-II NPS investments.

In case of Tier-I NPS, government employees will have to contribute 10% of (basic+DA) and the government will match that contribution. In case of non-government employees, the minimum contribution has to be Rs.500/- per month. In case of government employees, the money will be invested predominantly in government and corporate bonds only, while for non-government employees the corpus will be invested in equity, government bonds, corporate bonds, FDs and in money market funds.

Can I choose my asset mix like in 401-K in the US…

There are basically three choices available to the investor viz. E-Class, C-Class and G-Class. E-Class is the equity funds that are run by the designated fund managers. The fund managers are allowed to invest in the entire universe of F&O stocks. An investor can only invest up to a maximum of 50% of the corpus in the E-Class. The C-Class funds are those that invest in corporate bonds. Here the monitoring of rating is very important. Some of the fund managers had resorted to investing in lower grade bonds to earn higher returns and that is a distinct risk that it runs. The G-Class funds are those gilt funds that purely invest in government securities. Here the default risk is nil but there is a key interest rate risk that investors may run in case of rising interest rates. In case you do not want to make a choice, you can opt for “Auto Choice”. In this choice the asset allocation is done based on the age of the investor. Till the age of 35, up to 50% of the corpus will be invested in equity funds. After 35, for every passing year, 2% will be reduced from the equity component and 1% from the corporate debt component and re-allocated to government securities.

Comparing traditional EPF versus NPS…

Currently EPF is eligible for tax benefits under Section 80CCD (1) up to an outer limit of Rs.150,000 only. But in case of NPS, an additional limit of Rs.50,000/- is also available under Section 80CCD(2), which is over and above the base limit. This makes it more tax efficient. However there is a thaw. When an EPF is withdrawn, there is no tax on the same provided it is done after a period of 5 years. However, the NPS will be subject to tax in the hands of the investor when the amount under NPS is withdrawn. This EET (Exempt, Exempt, Taxed) treatment for NPS may dampen some of the enthusiasm that investors may have about NPS.

But the big advantage that NPS offers is more market driven returns. For example the EPF rate of return is determined each year and it is currently at around 8.65%. But with the government deciding to link small savings with market rates, this rate of return may go further down. From that perspective, NPS is more efficient. The corporate debt and G-Sec component offers nearly 10.5% to 11% yield on an annualized basis while the equity component offers nearly 13.5% to 14% yield. That surely makes it a more attractive return proposition.

These are early days for the NPS and there are some unfinished challenges. The KYC is currently quite complicated for NPS and that puts off many investors. That needs to be simplified. The government needs to rethink the EET treatment for NPS to put it at par with the EPF. That will be a first step in offering social security to a nation where majority of the population has hardly any social security to fall back upon.  That may be the good news.

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