The National Pension System (NPS) has become a popular investment option in recent years, with its tax benefits being a major draw. The government has added provisions for extra tax deduction while investing in NPS. But it is not advisable to invest in NPS for the sole purpose of claiming these deductions.
This article is meant to discuss the pros and cons of investing in NPS to avail the tax benefit, and help readers decide whether to invest in NPS or a different mutual fund scheme.
The Tax Benefits That Make NPS Worth Considering
The previous tax regime will continue as is for NPS. These tax reliefs are available:
NPS Tax Benefits as per Sec.80CCD (1): Rs. 1.5 lakh limit 1.5 lakh (which includes the amount available under Section 80C). Eligible NPS contribution is 20% of annual income or 10% of employee contribution (whichever is lower).
NPS Tax Benefits under Sec.80CCD (2): The limit for tax deduction is the least of the following amounts: Employee’s Gross Total Income, 10% of Basic + Dearness Allowance (or 14% of basic in case of CGE) or the amount of contribution made by the employer.
Under Sec.80CCD (1B): The NPS, individuals can avail a tax benefit of up to Rs. with their NPS investment. This section grants a total of 50,000 be claimed by both self-employed and employees. This will be on top of the tax benefit for 1, 50, 000/- in Sec. 80C.
In the new tax regime, tax benefits under Section 80C, 80CCD (1) and 80CCD (1B) will not be available. The employer contribution under Section 80CCD (2) is still eligible for tax deductions, however. There will be no tax advantages for Tier 2 accounts if the accounts are part of the new regime.
Exit from NPS
At the age of 60 years, the subscriber can avail the option to withdraw a maximum of 60% of the corpus in a lump sum. A 40% balance should be used to buy an annuity plan, which will give the subscriber a monthly pension.
If the subscriber has been invested in NPS for at least 5 years, he or she is allowed to withdraw 25% of the contribution up to three times during the period of subscription as a premature withdrawal. It is permissible only in exceptional cases such as Higher Education/ marriage children, buying residential houses, etc. But if anyone wants to exit NPS early, at least 80% of the corpus must be transferred to the annuity mode, and the buyer will get a monthly pension. The amount of balance can be withdrawn as a lump sum. But how taxes affect this lump sum withdrawal is difficult to determine.
In the event of a subscriber’s death, a nominee may withdraw the total amount available (without annuity) or opt for the annuity option, which pays monthly pensions.
Pros of NPS Investment for Tax Deduction
Better Tax Savings: Investing in NPS allows the investor to avail extra tax benefits, which means that the income earned after investing in NPS will be taxable income. This benefit is particularly beneficial to those in high tax brackets who want to maximise their tax deductions.
Long Term Retirement Planning: NPS is essentially a retirement corpus and hence is invested with the intention of long-term finances. Investors can maximise their retirement savings plan and reduce their tax liability by taking advantage of the tax benefits.
Flexibility and Control: NPS offers choice on investment options, ranging from equity funds to debt funds. This enables investors to tailor their investment portfolio in accordance with their risk profile and investment goals. Moreover, NPS provides regular updates on the performance of the investments, giving investors control over their retirement investments.
Option to choose allocation: Subscribers are provided with an option on how to allocate their funds into the Equity, Corporate Bond and Government Bond sections.
Cons of NPS Investment for Tax Deduction
Lock-in period: One of the disadvantages of NPS is the lock-in period. Except for partial withdrawals in certain cases, the invested money can be hardly retrieved until retirement. This lock-in period may restrict people’s liquidity if they plan to use their money in the short term.
Mandatory Annuity Purchase: At the time of retirement, a person has to use some of the corpus to buy an annuity. The annuity income will be taxable as per applicable tax slab. The issue is that this is an obligatory purchase of annuities and can limit flexibility of how the corpus is used for retirement income planning.
Uncertain Tax Treatment on premature Withdrawals: Taxation of withdrawals from NPS, particularly partial or premature withdrawals, is uncertain. Net returns from investing in NPS become complicated due to unclear tax implications of lump sum withdrawals and partial withdrawals.
Tax benefits on withdrawal: 60% of the total pension wealth is tax-free if withdrawn at the age of 60 or retirement. 40% of the remaining amount needs to be allocated to the purchase of an annuity, which will be taxed according to the tax slab applicable.
Conclusion:
Investing in NPS with the sole motive of claiming tax exemptions will require a thorough understanding of the pros and cons. The potential tax benefits can be significant, but there is a lock-in period, and the need to purchase an annuity could limit flexibility. Further, the tax treatment of withdrawals can be uncertain, which further complicates matters if the withdrawal is made prior to maturity. Before deciding, it is crucial to take into account any overall financial objectives, risk tolerance and liquidity needs. Try using our NPS return calculator to get a sense of what you might return with your NPS.
So, using NPS for investment should be considered as a long-term retirement planning option and not just as a way to save taxes. One can consult a financial advisor or tax expert to determine whether or not NPS is appropriate in a particular financial position. Keep in mind that tax savings are important, but should be factored into broader financial health and goals.