Basics of National Pension System
The National Pension Scheme (NPS) is a retirement solution that aims to help individuals plan for retirement and help accumulate wealth. Through regular contributions, users can get the provision of a monthly pension in later life. The Pension Fund Regulatory and Development Authority (PFRDA) governs NPS.
Who can open a National Pension System (NPS) account?
Any Indian citizen between the ages of 18 and 65 can open an NPS account.
However, NPS registration is compulsory for all Central Government employees who joined after 1st January 2004. Armed forces are an exception.
How does it work?
The aim of the National Pension System (NPS) is to create a retirement fund. You need to accumulate funds when you are working so that you can use the funds after retirement. So, we can classify it into two parts: the accumulation period and the withdrawal phase.
When you are 60, you get to take 60% of the accumulated corpus as lumpsum. This sum of money is tax-free withdrawal. You need to purchase an annuity with the remaining 40% of the funds. The annuity will take care of the regular monthly payments.
Categories of NPS
The National Pension System (NPS) offers two accounts for systematic and flexible investments: Tier 1 and Tier 2.
After you open an NPS account, you get Permanent Retirement Account Number (PRAN). The PRAN is required for fund management and making contributions.
Tier 1 NPS Account:
- Tier 1 account is the compulsory NPS account. The central government and state government employees, and other employees, have a Tier 1 account.
- This account has a set lock-in period that lasts till 60 years.
- A minimum deposit of Rs. 500 is required to open this account. It only allows for a partial withdrawal under limited circumstances.
- Contributions to Tier 1 accounts are eligible for tax deductions under Sections 80CCD (1) and 80CCD (1B). This means that you can invest up to Rs. 2 lakh in an NPS Tier 1 account and get a tax deduction on the entire amount, i.e. Rs. 1.50 lakh under Sec 80CCD(1) and Rs. 50,000 under Sec 80CCD (1B). The employer’s contribution to the NPS, up to a certain extent, is deductible under section 80CCD(2) when calculating the employee’s total income.
Tier 2 NPS Account:
- If you want to open a Tier 2 account, you must first have a Tier 1 account.
- This is a voluntary NPS account that allows members to withdraw funds as needed.
- You can make a minimum deposit of Rs.250 to open the account.
- Contributions to the NPS Tier 2 account are not tax-deductible.
Finally, contribution made by the employer up to 10 per cent of salary (Basic plus Dearness Allowance) can be claimed as a deduction from the taxable income under Section 80CCD(2) and is over and above the ceiling limit of Rs 1.5 lakh provided under Section 80C and limit of Rs 50,000 under Section 80CCD(1B). However, if you do not want to take tax advantage or have already opted for the New Tax Regime (Section 80CCD(2) is allowed), NPS tax benefits will not be of help to you.
When you invest in NPS, you have the option in various asset classes, like debt- corporate and government securities, equity and alternative investment funds. Depending on your risk tolerance and age, you get to invest in these different asset classes.
You have two investment options to invest in your NPS Account:
- Active Choice
- Auto Choice
Let’s understand each one of them.
What is Active Choice in NPS?
- You can choose the percentage allocation in asset classes.
- Equity, corporate debt, government securities, alternative investment funds, or AIF are the four asset classes available under the active option.
What is Auto Choice in NPS?
- Your investment is automatically distributed among different asset classes in a pre-defined percentage based on your age in auto choice.
- Depending on your risk tolerance, you can select an aggressive, moderate, or conservative option.
Here’s the asset break up under the different options of Auto choice:
Aggressive:The maximum equity exposure is capped at 75% for individuals up to the age of 35
Moderate : The maximum equity exposure is 50% for individuals up to the age of 35
Conservative : The maximum equity exposure is 25% for individuals with a maximum equity exposure of 50%.
Implications & How to decide :
NPS makes for a good retirement savings scheme – It is an investment tool by govt that aims to help you build a retirement fund. However it comes with some drawbacks as well when compared to other retirement investment avenues like PPF / MF / Stock Markets etc.
NPS may not be the best scheme to invest in if your aim is to save for other financial goals like Home Purchase, children’s education, daughter’s marriage etc. For all of these needs, investments in either a PPF / or growth assets like Mutual funds / Equities etc score over NPS as better goal based options.
When compared to PPF, PPF scores in terms of Flexibility Partial withdrawals are allowed in PPF after the 7th year onwards with some limitation. Loans during the 3rd and 6th financial years of opening the account are available; but subject to conditions. You cannot invest 100% in equities in an NPS.
If you have a outstanding loan – home / car or any other loan , it makes sense channelize funds towards saving to prepay loan before investing in an NPS.
NPS is a long term savings scheme aimed specifically to create a corpus for post-retirement needs. If someone opens an NPS account at age 30, the NPS will mature when he or she is 60 and then there is a provision of lifetime pension. It means, the NPS account (Tier I) that you open today could stay with you for several decades from now. Early exit from NPS is allowed but to surrender and withdraw before maturity will not serve the purpose well and hence knowing about the structure beforehand helps.
NPS has several tax benefits and can help you bring down the tax liability. Under Section 80CCE, the aggregate amount of deduction under sections 80C, 80CCC and Section 80CCD(1) can be availed up to Rs.1. 5 lakh. In addition, a deduction is allowed under section 80 CCD(1B) in respect of any amount invested in NPS up to Rs. 50,000. Finally, contribution made by the employer up to 10 per cent of salary (Basic plus Dearness Allowance) can be claimed as a deduction from the taxable income under Section 80CCD(2) and is over and above the ceiling limit of Rs 1.5 lakh provided under Section 80C and limit of Rs 50,000 under Section 80CCD(1B). However, if you do not want to take tax advantage or have already opted for the New Tax Regime (Section 80CCD(2) is allowed), NPS tax benefits will not be of help to you.
If you are investing in NPS to withdraw the entire corpus on maturity, you need to relook at your objective. On maturity, you can withdraw a maximum of 60 per cent of corpus while the balance 40 per cent will have to be transferred to a life insurance company to provide a regular pension to you.
Under NPS, there is a fixed pension amount provided by the annuity provider depending on the interest rate prevalent during the retired years. If you want to use your savings directed towards retirement to be used as per your own wish, NPS may not suit you.
NPS being a long term investment, exiting from the scheme later on may prove detrimental while knowing how it works will help you accumulate the right amount for retirement. Before you open an NPS account and start saving, keep a note of the above important features and how it fits in your own financial life and suits you as an investor.
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