Benefits of NPS

The National Pension Scheme is a government-backed savings scheme open to all, but compulsory for government employees. It was launched in 2004, solely for government employees to replace the old pension scheme, but was opened to all sections in 2009. The scheme’s primary aim is to promote retirement planning. NPS is a market-linked scheme, which functions as a mix of a pension and investment plan. Subscribers are allowed to withdraw 60 percent of the corpus after retirement, but the balance amount has to be mandatorily invested in an annuity plan. Investors are free to choose the mix of equity and debt exposure according to their risk profile and return expectations. Being a market-linked scheme, NPS is likely to generate better returns than other savings schemes.     

Structure of NPS

To understand the benefits of NPS, one should have a clear idea of the structure of the scheme. There are two types of accounts under NPS—Tier 1 and Tier 2.

The Tier 1 accounts are further divided into NPS (Central Govt), NPS (State Govt), NPS (Corporate) and NPS (All Citizens Models). There is a difference in rules governing Tier 1 and Tier 2 accounts, but the broad contours are similar. As the NPS has replaced the Old Pension Scheme, the government contributes an amount equal to 14 percent of the basic salary in NPS accounts of its employees.

The basic difference between Tier 1 and Tier 2 accounts is that the former is primarily a retirement account and doesn’t promote withdrawal before retirement. The Tier 2 account can only be opened after opening a Tier 1 NPS account. Private sector employees and self-employed people can invest in a Tier 2 account and withdraw anytime with complete freedom without any lock-in period or penalties.

On the other hand, there are restrictions on withdrawals from a Tier 1 account. Any kind of withdrawal from a Tier 1 account is allowed only after a minimum investment tenure of three years. Only three partial withdrawals are allowed during the entire tenure of the NPS account, that too for specific reasons like medical emergency or marriage. If you want to exit prematurely, you can only withdraw 20 percent of the corpus, while the balance 80 percent has to be invested into an annuity. A Tier 1 NPS account matures at the age of 60 and 60 percent of the accumulated corpus can be withdrawn, while the balance has to be used for an annuity.

Benefits of NPS

NPS has largely been accepted as the default retirement savings scheme in India. Most of the benefits associated with NPS are for investments in Tier 1 accounts. Contributions to an NPS account provides several advantages such as flexibility, tax benefits and returns.

  • Returns: Investors in the scheme have an option to decide the proportion of allocation to different instruments such as equity, government bonds, fixed return instruments and alternative investment funds. Though the exposure to equity has been capped at 75 percent to limit the risk, it is still likely to generate substantial returns. With investments in government bonds and fixed-return instruments, investors are protected from fluctuations in the equity markets. Investments in NPS have delivered 8-10 percent annualized returns in over a decade.
  • Flexibility: One of the biggest advantages of NPS is the flexibility associated with the investments and the fund managers. Subscribers to the scheme are offered two options—active choice and auto choice. Four investment schemes are offered under the active choice. Investments in government bonds are known as Scheme G, fixed income instrument investments are known as Scheme C, while investments in equities and alternative investment funds are called Scheme E and Scheme A, respectively. An investor can put in his/her money in any of the schemes, but investments in the equity scheme are capped at 75 percent. NPS allows you to choose from eight fund managers to manage your investments. If you are not satisfied with the performance, you can change the fund manager once and the allocation mix twice in a year.

If you do not want to be actively involved in asset allocation, you can choose the auto option. The auto choice options change the allocation mix according to the age of the investor. It starts with a higher allocation to equity when you are young and gradually moves to relatively safer investment assets.

  • Tax Benefits: Investment in NPS comes with a plethora of tax benefits. A contribution of up to Rs 1.5 lakhs per annum to NPS account is eligible for tax deduction under Section 80CCD(1) and 80CCD(2) of the Income Tax Act. The tax deduction under these sections is limited to 20 percent of the salary for employees. Similarly, for self-employed, the maximum contribution eligible for tax deduction is capped at 20 percent of the income. Investments into NPS also qualify for an additional tax deduction of Rs 50,000 under Section 80CCD (1B), taking the total tax benefits on contribution to Rs 2 lakhs.

NPS effectively has an Exempt-Exempt-Exempt or EEE status, which means investment, accumulation and withdrawal has been made tax-free in NPS. Investors are allowed to withdraw 60 percent of the corpus after maturity and 40 percent has to be invested to buy an annuity plan. Earlier, only 40 percent of the withdrawal was tax-free, but recently the government made the entire amount tax-free. The 40 percent that has to be invested for an annuity is already tax-free. However, the income from the annuity plan will be taxed as per the income slab.

  • Low-Cost Investment: NPS investors have an option to invest in different instruments and change the allocation mix. The fund is managed by Pension Fund Managers. Pension Fund Managers are professional fund managers who work with an objective to maximise returns with manageable risk. Being a government-backed retirement savings scheme, the managing fee is nominal. Fund managers charge 0.01 percent to manage the pool of funds which is a boon for investors. NPS subscribers get the flexibility to change asset mix and receive professional management services for a relatively low price. 

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