What is NPS (National Pension Plan) & How Does it Work

What is NPS (National Pension Plan) & How Does it Work

What is NPS

It is a defined contribution pension system in which the contributions are invested in a mix of assets and the retirement corpus is dependent on the returns from those assets. The returns in NPS are market-linked. Dedicated pension fund managers are entrusted with the task of managing the investors' money. 

A person needs to contribute to NPS till age of 60 years. The minimum annual contribution to the pension account (or Tier I account) is Rs.6,000.

How Does NPS Operate

A person needs to contribute to NPS till age of 60 years.

Options Available to Invest Under NPS

Under NPS there are 2 Tier namely Tier 1 & Tier II Accounts

Tier I Account

The minimum annual contribution to the pension account (or Tier I account) is Rs. 6,000/-.

Investments are market-linked & one can choose any of the three funds

1.      Government Securities Fund

2.      Fixed-Income Instruments other than government securities fund

3.      Equity Fund

An Investor can’t put more than 50% of your money in the Equity Fund.

At 60, you can have up to 60% of this money in a lump sum & buy an annuity product with the rest.

Deferred exit options are available.

Early exits are discouraged by mandating 80% of the accumulated corpus to buy an annuity. Rules now allow for partial withdrawals up to 25% of the contributions for specific purposes

Ø  Under NPS, an investor can open two accounts, called Tier I and Tier II account.

Ø  Tier I account is a non-withdrawable permanent retirement account.

Ø  Tier II is a voluntary withdrawable account.

Ø  Tier II account can be opened only when you have an active Tier I account.

Ø  The minimum contribution in Tier I account is Rs.500/- for all transactions & Rs. 6,000/- for a year.

Ø  For Tier II account, the minimum contribution for opening an account is Rs.1,000/- & Rs.250/- is charged for subsequent transaction. 

What Choices Does Investor Have under NPS to Grow his Corpus?

An investor in NPS has two choices to invest in, namely Auto choice & Active choice.

Ø  In the Auto choice, the allocation amongst assets is done as per a predetermined formula based on the age of the investor.

Ø  The allocation is made in 3 asset classes, namely

o   Equities (E),

o   Corporate Bonds (C)  

o   Government Securities (G)

Ø  Under Active choice, the choice of allocation lies with the investor. There is however a cap of 50% for investment in equity. For government sector, the cap on equity is increased to 15%.

On turning 60, an investor can exit from the NPS but 40% of the pension wealth has to be utilised for the purchase of an annuity. If an investor withdraws the corpus before reaching 60 years of age, he will have to invest 80% of the accumulated corpus for buying an annuity. These exit conditions only apply to the NPS Tier I account, which is a pre-requisite for having a Tier -II account in NPS. 

Tax Benefits

1.      As per current tax laws, investment of up to 10% of basic pay plus dearness allowance or a maximum of Rs 1.5 lakh, whichever is lower, is deductible from gross taxable income. 

2.      From FY2015-16, an investor is allowed an additional deduction of Rs 50,000 from gross taxable income for investing in NPS.

3.      This deduction is over and above the maximum tax deduction of Rs 1.5 lakh under Section 80C.

4.      Hence the total tax benefit for investing in NPS is Rs 2 lakh.

5.      Only an investor in Tier I account can claim the above tax benefits. 

6.      NPS is currently subject to the Exempt Exempt Tax (EET) structure. This means that contributions to NPS and accumulation/growth of these are not taxed, but the lump sum withdrawn on exit from NPS is taxed.

7.      The amount that is used to buy the annuity is however not subject to tax. This means that if an investor uses 100% of the accumulated corpus for buying an annuity, then he won't be subject to taxation.

8.      Only the pension income that he gets will be taxed like any other pension.

9.      In Budget 2016, the finance minister has made withdrawals from NPS on maturity tax-free up to 40% of the total corpus accumulated. This is a welcome step as it has made NPS more attractive for investors. 

Should You Invest Now?

Basic tenets of personal finance say investments need to be goal-oriented & tax-saving should be incidental to them. NPS is a good fit to these rules as it is a goal-oriented product that helps you build a retirement nest egg.

Meeting a goal or a long-term requirement is an essential need for investments & NPS is a good product for retirement.

You could consider investing in it, not for tax saving but for investing for your retirement days. So, more than putting Rs.50,000/- in NPS, make sure you have such a need & would be able to invest on a regular basis.

So should you invest only in NPS for retirement? No, currently as it is taxable on maturity, which hope will get rectified soon.

NPS is not very liquid.

Also, one needs to compulsorily buy annuity with 40% of the money. Which is why recommendation being that NPS be one of the vehicles for investment.

Moreover, as the market for ETFs (exchange-traded funds) develops, we would recommend ETFs for long-term investments.

Hence, a complete investment in the NPS at the moment is not advisable to one who is looking to park more as investment rather than looking out to save tax.

So, consider it as a part of your investment strategy for retirement.

But don’t chase the extra tax-saving alone.

Happy Investing

RN