National Pension System (NPS): A Comprehensive Guide to Retirement Planning

Investment Options: Crafting Your Retirement Corpus

The NPS offers a flexible and transparent investment platform, allowing subscribers to tailor their portfolio based on their risk appetite and financial goals. Subscribers have the choice of two primary investment approaches:

1. Active Choice: This option empowers the subscriber to actively decide the asset allocation of their contributions across four distinct asset classes:

• Equity (Asset Class E): High-risk, high-return investments in the stock market. The maximum allocation to this asset class is capped at 75% of the total contribution.

• Corporate Bonds (Asset Class C): Medium-risk investments in debt securities issued by companies.

• Government Securities (Asset Class G): Low-risk investments in securities issued by the central and state governments.

• Alternative Investment Funds (Asset Class A): This class includes investments in instruments like Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs), with a cap of 5% of the portfolio.

2. Auto Choice (Lifecycle Fund): This is the default option for subscribers who do not wish to actively manage their investments. The asset allocation is automatically adjusted based on the subscriber's age. As the subscriber gets older, the exposure to equity is gradually reduced, and the allocation to more stable assets like government securities is increased. There are three lifecycle fund options available:

• LC75 – Aggressive Life Cycle Fund: Starts with a 75% allocation to equity until the age of 35, which then tapers off with age.

• LC50 – Moderate Life Cycle Fund: Begins with a 50% allocation to equity until the age of 35, gradually decreasing thereafter.

• LC25 – Conservative Life Cycle Fund: Has a modest 25% allocation to equity until the age of 35, which reduces over time.

Subscribers also have the liberty to choose from a list of PFRDA-appointed Pension Fund Managers (PFMs) who are responsible for managing their investments.

Withdrawal Options: Accessing Your Savings

The NPS is primarily a long-term retirement savings product with specific rules for withdrawal. These are categorized as follows:

1. Upon Superannuation (attaining 60 years of age):

• A minimum of 40% of the accumulated corpus must be utilized to purchase an annuity plan from an Annuity Service Provider (ASP) registered with PFRDA. This annuity provides a regular monthly pension to the subscriber.

• The remaining 60% can be withdrawn as a lump sum, which is tax-free.

• If the total corpus is less than or equal to ₹5 lakh, the subscriber has the option to withdraw the entire amount as a lump sum without the mandatory requirement of purchasing an annuity.

2. Premature Exit (before attaining 60 years of age):

• A subscriber can exit the NPS after completing five years in the scheme.

• A minimum of 80% of the accumulated corpus must be used to purchase an annuity.

• The remaining 20% can be withdrawn as a lump sum.

• If the total corpus is less than or equal to ₹2.5 lakh, the entire amount can be withdrawn as a lump sum.

3. Partial Withdrawal:

• After a lock-in period of three years, subscribers are allowed to make partial withdrawals from their Tier I account for specific purposes.

• These purposes include higher education or marriage of children, purchase or construction of a residential house, and treatment of specified critical illnesses.

• A maximum of 25% of the subscriber's own contribution can be withdrawn.

• A maximum of three such partial withdrawals are permitted during the entire tenure of the NPS subscription, with a gap of at least five years between two withdrawals (this condition may be relaxed for medical emergencies).

4. Upon the Death of the Subscriber:

• The entire accumulated corpus is paid to the nominee or legal heir of the subscriber.

• The nominee has the option to either withdraw the entire amount or purchase an annuity.

Rate of Interest or Return on Investment: Market-Linked Growth

The NPS does not offer a fixed rate of interest. The returns are market-linked and depend on the performance of the underlying assets chosen by the subscriber. Historically, returns on NPS investments have ranged from 9% to 12% per annum, which is competitive when compared to other long-term savings instruments. The final return is a direct consequence of the chosen asset allocation and the performance of the selected Pension Fund Manager.

Maturity Period and Options: Planning for the Long Haul

The maturity period of the NPS is aligned with the subscriber's retirement age, which is typically 60 years. However, the scheme offers flexibility beyond this age:

• Continuation of NPS Account: Subscribers can choose to continue contributing to their NPS account until the age of 75. This allows for further accumulation of their retirement corpus.

• Deferment of Withdrawal: A subscriber can defer the withdrawal of the lump-sum amount until the age of 75. They can also defer the purchase of the annuity for a maximum of three years from the date of superannuation.

• Phased Withdrawal: The lump-sum amount can be withdrawn in a phased manner, either annually or in installments, up to the age of 75.

Lock-in Period: A Commitment to Retirement Savings

The NPS Tier I account has a lock-in period until the subscriber reaches the age of 60. This is to ensure that the funds are utilized for their intended purpose of providing a post-retirement income. However, as detailed in the withdrawal options, provisions for premature exit and partial withdrawals exist under specific circumstances.

The NPS also offers a Tier II account, which is a voluntary savings account. There is no lock-in period for the Tier II account, and subscribers can withdraw their funds at any time. However, contributions to the Tier II account do not offer any tax benefits.

Other Salient Features of NPS:

• Portability: The NPS account is portable across jobs and locations. The Permanent Retirement Account Number (PRAN) remains the same irrespective of a change in employment or city.

• Transparency: Subscribers have online access to their NPS account, allowing them to track their investments and make changes to their fund manager or investment choice.

• Low Cost: The fund management charges in NPS are among the lowest in the world, ensuring that a larger portion of the subscriber's contribution is invested for their future.

Income Tax Implications: A Triple Tax Benefit

The National Pension System offers an attractive tax structure, often referred to as the Exempt-Exempt-Exempt (EEE) status, at various stages of the investment lifecycle.

1. On Contribution:

• Section 80CCD(1): An individual can claim a deduction of up to 10% of their salary (Basic + Dearness Allowance) or 20% of their gross total income for the self-employed, within the overall ceiling of ₹1.5 lakh under Section 80C of the Income Tax Act, 1961.

• Section 80CCD(1B): An additional exclusive deduction of up to ₹50,000 is available for contributions made to the NPS. This is over and above the ₹1.5 lakh limit under Section 80C.

• Section 80CCD(2): In the case of salaried individuals, the employer's contribution to the NPS is also eligible for a deduction of up to 10% of the salary (14% for central government employees). This deduction is not subject to the overall limits of Section 80C.

2. During Accumulation:

• The returns generated on the investments during the accumulation phase are entirely tax-free. The power of compounding works without any tax drag.

3. On Withdrawal and Maturity:

• Lump-Sum Withdrawal: The 60% of the accumulated corpus that can be withdrawn as a lump sum upon superannuation is completely exempt from income tax.

• Annuity Purchase: The 40% of the corpus that is mandatorily used to purchase an annuity is also not taxed at the time of purchase.

• Annuity Income: The monthly pension received from the annuity is treated as income and is taxed as per the individual's applicable income tax slab in the year of receipt.

• Partial Withdrawals: Partial withdrawals made under the specified conditions are tax-exempt.

• Premature Exit: The lump-sum amount withdrawn on premature exit (up to 20% of the corpus) is taxable as per the individual's income tax slab.

• Death Benefit: The entire corpus received by the nominee upon the death of the subscriber is tax-free.

The National Pension System (NPS) offers a dual-account structure to its subscribers. While the Tier I account is the primary retirement account with stringent withdrawal rules and significant tax benefits, the Tier II account is a voluntary, open-access savings account that offers greater liquidity. This detailed report elaborates on the features of the NPS Tier II account, with a specific focus on the tax implications of investments and withdrawals.

Understanding the NPS Tier II Account

The NPS Tier II account can be opened only by subscribers who have an active Tier I account and a Permanent Retirement Account Number (PRAN). It functions like a regular savings account, but with the added advantage of being managed by professional pension fund managers.

Key Features of the Tier II Account:

• Voluntary Nature: Opening and contributing to a Tier II account is entirely at the discretion of the subscriber.

• No Lock-in Period: Unlike the Tier I account, the Tier II account does not have a mandatory lock-in period. Subscribers can withdraw their funds at any point in time, offering high liquidity.

• Flexible Withdrawals: There are no restrictions on the number or amount of withdrawals from a Tier II account.

• Investment Choices: Subscribers have the same investment choices (Active or Auto) and can select from the same list of Pension Fund Managers (PFMs) as available for the Tier I account.

• No Minimum Balance Requirement: While an initial contribution is required to open the account, there is no mandate to maintain a minimum balance thereafter.

• Easy Fund Transfer: Subscribers can transfer funds from their Tier II account to their Tier I account, but not vice versa.

Tax Implications on Investment in NPS Tier II

The tax treatment of contributions made to an NPS Tier II account is a crucial aspect to consider. For the majority of subscribers, investments in the Tier II account do not offer any tax benefits.

For General Subscribers (Private Sector Employees, Self-employed, etc.):

• Contributions made to the NPS Tier II account are not eligible for any tax deductions under the Income Tax Act, 1961. This is a significant point of distinction from the Tier I account, which offers tax benefits under Section 80C, Section 80CCD(1B), and Section 80CCD(2).

Exception for Central Government Employees:

• A specific provision has been made for Central Government employees. They can claim a tax deduction under Section 80C of the Income Tax Act for contributions made to their NPS Tier II account, up to the overall limit of ₹1.5 lakh.

• However, this tax benefit comes with a mandatory lock-in period of three years for the contributed amount. During this period, the funds cannot be withdrawn.

Tax Implications on Withdrawal from NPS Tier II

The taxability of withdrawals is another critical factor for subscribers. Unlike the tax-free lump-sum withdrawal from the Tier I account upon maturity, withdrawals from the Tier II account are subject to taxation.

Taxation on Gains:

• When a subscriber withdraws funds from their NPS Tier II account, the gains or profits earned on the investment are taxable.

• These gains are added to the individual's total income for the financial year and taxed according to their applicable income tax slab.

It is important to note that the entire withdrawal amount is not taxed. Only the appreciated component (the difference between the withdrawal amount and the invested amount) is subject to tax.

Example:

Suppose a subscriber invested ₹1,00,000 in their NPS Tier II account and after a certain period, the value of the investment grew to ₹1,20,000. If the subscriber decides to withdraw the entire amount, the taxable portion would be the gain of ₹20,000 (₹1,20,000 - ₹1,00,000). This ₹20,000 will be added to their income and taxed as per their income tax slab.

Who Should Consider an NPS Tier II Account?

Given its features and tax implications, the NPS Tier II account is suitable for:

• Existing NPS subscribers who are looking for a flexible investment option with the potential for market-linked returns.

• Individuals who have exhausted their tax-saving limits under Section 80C and are seeking an additional investment avenue.

• Investors who are comfortable with the market risks associated with equity and debt instruments.

• Central Government employees who wish to avail the additional tax-saving opportunity under Section 80C, provided they are willing to accept the three-year lock-in period.

In conclusion, the National Pension System presents a robust and well-regulated framework for individuals to build a substantial retirement corpus in a tax-efficient manner. Its flexibility in investment choices, coupled with the potential for market-linked returns and significant tax advantages, makes it a compelling long-term savings and investment vehicle for securing a financially independent future.

The NPS Tier II account serves as a valuable supplement to the primary Tier I retirement account. While it lacks the tax benefits on investment for most subscribers, its high liquidity and professional fund management make it an attractive short-to-medium-term investment option. Subscribers must, however, be mindful of the tax implications on the gains at the time of withdrawal and plan their finances accordingly.