New Pension Scheme (NPS) has got quite popular in the last few years due to favourable tax announcements. In this post, I will discuss NPS basics, tax benefits on investment and tax treatment at maturity. Finally, I will discuss whether you should invest in NPS.
NPS Is a Defined Contribution Pension Plan
Under a defined contribution plan, you control the contribution to the pension account but you do not control your pension income. Your pension (or annuity income) will depend on the performance of your investment and the prevailing annuity rate at the time of your retirement. This is in sharp contrast to the concept of pension for old Government employees (joining before 2004), where pension was linked to last drawn salary. Such schemes are defined benefit schemes, where the benefit is defined.
Under NPS, you contribute to your NPS account before retirement. Your investment earns market linked returns. When you retire, you can withdraw a portion of accumulated corpus as lump sum while the remaining must be utilised to purchase an annuity plan.
What Is an Annuity Plan?
Under an annuity plan, you purchase an income stream for life time (of fixed number of years) from an insurance company by paying it a lump sum. For instance, if you invest Rs 10 lacs an immediate annuity plan and the prevailing annuity rate is 6%, you will get Rs 60,000 per annum for your lifetime from the insurance company. Do note NPS does not provide annuity income. Annuity plan has to be purchased from one of the empanelled insurance companies. When you retire, your salary stops. Regular income from annuity plan can replace your salary at least to some extent.
- Anyone between the age of 18 and 60 can open NPS account.
- You do not have to be a salaried professional to open an NPS account.
- There are two broad NPS models, for Government employees and All Citizens Model.
- There are three assets classes viz. Equity (E), Government Securities (G) and Corporate debt (C).
- The maximum allocation to Equity (E) is capped at 50% for subscribers under All Citizens Model. For Government subscribers, it is capped at 15%.
- There are two investment options. Under Active Choice mode, you select the allocation to different asset classes E, C and G. The cap for equity investment still applies.
- Under Auto Choice mode (lifecycle fund), equity exposure is automatically reduced as you move closer to retirement.
- You can have two types of NPS accounts i.e. Tier I and Tier II NPS accounts. You cannot open Tier II account unless you have opened Tier I account.
- All the tax benefits for NPS are limited to your investment in Tier I NPS account.
- There is no tax benefit for investment in Tier II NPS account.
- Tier II NPS account is like an open ended mutual fund. There are no withdrawal restrictions as in case of Tier I account. You can withdraw your investment whenever you want.
- You must deposit a minimum of Rs 1,000 per financial year in your Tier I NPS account. There is no maximum limit.
How can I open NPS account?
You can open the NPS account through your employer (if you employer offers NPS). Alternatively, you can open it on your own. You can visit the nearest Point of Presence (PoP) of NPS. You can open NPS account at most bank branches. You can also open NPS account online using your Aadhaar card or using a combination of PAN card and bank account details. You must visit eNPS portal to open the account online.
Once you open NPS account, you are allotted a Permanent Retirement Account Number (PRAN). You can have only one PRAN. This implies you cannot open two NPS accounts (Tier I accounts). PRAN is completely portable. You can retain the same PRAN while switching jobs or even after quitting your job.
What Are the Tax Benefits for Investing in NPS?
Tax benefits are limited to investments in Tier I NPS account.
|80CCD(1)||Up to Rs 1.5 lacs|
Additional cap of (Basic Salary + Dearness Allowance)
|Not an exclusive tax benefit.|
Shares the limit with Section 80C investments such as PPF, EPF, insurance, principal repayment of a housing loan etc.
Section 80CCE caps the total tax benefit under Section 80C, 80CCC and 80CCD(1) at Rs 1.5 lacs per financial year.
|80CCD(1B)||Up to Rs 50,000|
|Exclusive tax benefit.|
You cannot use this benefit for any other investment.
|80CCD(2)||Capped at 10% of (Basic Salary + Dearness Allowance)|
|Not available to self-employed.|
Only applicable for employer contribution to your NPS account.
Therefore, you can claim up to a maximum of Rs 2 lacs for own investments in NPS Tier I account. Of this amount, Rs 50,000 is an exclusive benefit under Section 80CCD (1B).
What Happens When You Retire or Turn 60?
You must use at least 40% of the accumulated corpus to purchase an annuity plan. Remaining 60% can be withdrawn as lump sum. Do note you can even use the entire corpus to purchase an annuity plan. Depending upon your choice, ratio of annuity purchase and lump sum withdrawal can be 40:60, 50:50, 80:20 or even 100:0. The only restriction is that at least 40% should be used for annuity purchase. If you wish, you can defer the purchase of annuity plan by up to 3 years. For the remaining portion, you can withdraw the amount at one go or stagger withdrawals till the age of 70 in annual instalments. Subscribers under All Citizens model can even continue investing in NPS account till the age of 70, if they so desire. This flexibility is not available to Government Subscribers.
What Is the Tax Treatment at Maturity?
At least 40% of the corpus must be utilised to purchase annuity plan. Annuity income is taxed in the year of receipt at your marginal income tax rate (income tax slab). 40% of the accumulated corpus can be withdrawn tax free (as lump sum).
What about the remaining 20%? Well, it is your choice. You can either utilise the amount to purchase an annuity plan (purchase annuity for 60% of the corpus and not 40%). Alternatively, you can withdraw the amount in 9 annual instalments till the age of 70. Annuity income, as mentioned before, will be taxed in year of receipt. Lump sum withdrawal (over and above 40%) shall be added to your income and taxed accordingly.
You must decide the break up between annuity purchase and lump sum withdrawal based on your requirement and tax efficiency.
What If I Want to Exit NPS before Retiring or Turning 60?
You can do that but there is a strong deterrent. In case you exit the NPS before superannuation (retirement) or turning 60, you will have to compulsorily use 80% of the accumulated corpus to purchase an annuity plan.
Limited Partial Withdrawals Are Permitted
Yes, partial withdrawals are permitted for treatment of specified critical illnesses, child education or marriage or purchase of first house. However, there are many restrictions. First partial withdrawal is permitted only after 10 years. Moreover, only three withdrawals are permitted and each withdrawal should have a gap of 5 years. The condition of gap of 5 years is not applicable in case of critical illnesses. And you can withdraw only up to 25% of own contribution. Clearly, NPS scores very low when it comes to liquidity.
Should You Invest in NPS?
Now the million dollar question. Should you invest in NPS?
Every pension plan (and NPS is no different) has an accumulation phase followed by distribution phase. So, by investing in a pension plan, you contribute to the corpus till your retirement. When you retire, you use the accumulated corpus to purchase an annuity plan. You could have accumulated this amount in another investment product, say mutual funds and used the amount to purchase an annuity plan at the time of retirement. By doing so, you would have avoided restrictions on investments (maximum 50% in equity), restrictions on withdrawals and mandatory purchase of annuity (annuity rates are low). You would have been free to corpus as you want. Going by this, it makes little sense to invest in NPS.
However, NPS offers an exclusive tax benefit of Rs 50,000 under Section 80CCD(1B). Though investment decisions should not be driven by tax considerations alone, taxation is an important part of decision making. If you fall in 30% tax bracket, you can easily save Rs 15,450 (including cess) by investing Rs 50,000 in NPS. You are already paying tax at the highest rate (if you don’t invest in NPS). And you know that 40% of the accumulated corpus is exempt from tax at the time of exit from NPS. Hence, there is clear potential for tax saving. You can save some tax by planning your lump sum withdrawals and annuity purchase accordingly.
Here Is My Take on NPS.
- NPS is better suited to investors in the highest income tax bracket.
- Even investors in the lower income tax bracket can invest. However, tax saving will be less. Quite possible you have to pay tax at lower rate now but you may have to pay higher tax rate later because the corpus would have grown by the time you retire.
- Do not invest more than Rs 50,000 per financial year in NPS. This is because exclusive tax benefit under Section 80CCD(1B) is capped at Rs 50,000 per annum.
- Do not invest in NPS to fill your Section 80C limit of Rs 1.5 lacs. There are much better investment products in Section 80C to meet that limit. I will pick PPF and ELSS over NPS to fill Section 80C limit of Rs 1.5 lacs.
- Ensure that NPS does not crowd out your other investments.
- NPS should only be a small part of your investment. Do not make NPS your primary investment for retirement.
- Do not ignore liquidity restriction in NPS especially if you plan to retire early.
Are you planning to invest in NPS? Let me know in the comments section.