Most investors, particularly salaried persons, are split on whether they should invest in mutual funds or the National Pension Scheme (NPS). People may favor pension plans because of the significant tax benefits they provide over mutual funds. The option to withdraw the 60% lump-sum amount in instalments upon retirement strengthens their argument even further.
I’m assuming you know something about NPS. Anyhow, let us try to review about NPS in this blog-post.
First, let us see a quick history about NPS. The government launched the NPS in 2004 to reform its pension plan (this was for the central government employees) by shifting from a defined benefit plan to a defined contribution plan. In the former, known as the defined benefit plan, the government provided a set sum on a regular basis after retirement. The former plan paid out 50% of the last received salary as a pension to central government employees. However, with the move to NPS, the government makes a fixed contribution amount after retirement, and the amount disbursed is dependent upon the size of the corpus built at the time of retirement.
While the NPS scheme was initially established solely for government employees, it was expanded in 2009 to include all Indian residents aged 18 to 70. The Pension Fund Regulatory and Development Authority (PFRDA) administer and regulate the National Pension Scheme (NPS).
Individual contributions to NPS are taxed more favorably than mutual funds on two fronts. To begin, tax deductions of up to Rs. 50,000 per year (under Section 80 CCD (1B)) can be claimed in addition to the Rs. 1.5 lakh limit set under section 80C of the Income Tax Act for individuals.
To demonstrate its advantages, suppose a person in the 30% tax band wishes to invest Rs. 1.5 lakh in an NPS account. Individuals can claim tax deductions for contributions to NPS at the end of the fiscal year when submitting returns, saving money that would otherwise be taken from their salary as tax.
This is not applicable with mutual funds, except that they belong to equity linked savings schemes (ELSS), which can be claimed as a deduction under section 80C. Investments in other forms of mutual funds are not tax deductible.
Aside from the 1.5 lakh per year, about 10% of a corporate employee’s basic pay + dearness allowance (up to Rs. 7.5 lakh per year) can be claimed as deductions if enrolled as an employer contribution.
Subscribers to NPS also have another perk. The 60% of the corpus is tax-free when withdrawn (but the 40% of the corpus is taxable when provided as annuity). However, capital gains from equities mutual funds are taxed at 10% at the point of redemption, whereas debt mutual funds are taxed at the individual’s slab rate.
NPS is appropriate for most people who do not have much time to invest. On the other hand, those who have the necessary experience or investment adviser’s help may make more effective asset allocation decisions using mutual funds. NPS outperforms solution-oriented funds such as retirement mutual funds because such funds cannot create individual-specific asset allocations, and all investors in a retirement mutual fund get the same asset allocation portfolio, whereas in NPS, asset allocations change actively for each subscriber based on their age and risk appetite.
To be certain, all funds put in NPS are locked in until the age of 60. After that, you can withdraw 60% of the corpus as a lump amount and invest the remainder in an annuity plan. The annuity payment is entirely taxed at the individual’s slab rate.
NPS also offers a systematic lump sum withdrawal plan (SLW) to its pensioners. This simply means that investors may withdraw a portion of the 60% lump sum value at their preferred intervals (monthly, quarterly, semi-annually, or annually) and choose the amount they wish to withdraw each time.
Before this process, consumers had to withdraw the whole lump sum amount (which is 60% of the total NPS corpus) all at once when they reached the age of 60, or issue redemption requests once a year to withdraw the funds. The SLW, which is identical to the mutual fund withdrawal plan, allows them to fully automate this procedure of redemption. Assuming a person has saved Rs. 1 crore in an NPS account by the age of 60, 60 lakhs, or 60% of the corpus can be taken as a tax-free lump-sum amount, with the balance 40 lakh utilized to purchase an annuity plan. This annuity amount will be taxed at the slab rate.
The main criticism raised against NPS is the obligation to invest 40% of the corpus in annuity plans. This is due to the fact that annuities pay just 6-7% yearly interest, but NPS Tier 1 Equity funds pay an average of 13.31% annually. The 10-year average return of NPS Equity funds (13.31%) is also higher than that of Nifty Bees (13.27%) and the large cap mutual funds (12.21%).
NPS subscribers can use the SLW option to get regular pensions while deferring the annuity until they reach the age of 75. As a result, the 40% invested in annuities will benefit from an additional 15 years of tax-free compounding until the individual reaches the age of 75.
Prior to SLW, NPS subscribers may withdraw the 60% lump sum payment and invest it in a debt or equities mutual fund or bank fixed deposits, with the option of making systematic withdrawals. The downside is that, in addition to the entry and exit fees, capital gains tax must also be paid when withdrawing money from these mutual funds or from the fixed deposits. Also, if MF unit-holders choose to change the plan in which they have invested, they must pay the required capital gains tax and exit loads. In NPS, however, the fund manager can be changed once or twice a year at no cost.
You can also utilize up to 25% of your NPS balance before turning 60. This option is known as partial withdrawal and can be used in specific circumstances. These instances include children’s further education, marriage, house purchase or construction, hospitalization of oneself or a family member, medical expenditures resulting from disability, or the start-up of a new endeavour or business. But you can only make three withdrawals from your NPS account during its lifetime.
On the contrary, if you want to exit entirely from the NPS scheme, you must have completed at least 5 years in the NPS, and the subscriber can withdraw up to 20% of the corpus as a lump sum, with the remaining 80% should be used to purchase an annuity plan to receive the pension. If the cumulative NPS corpus is less than Rs. 2.5 lakh, the subscriber receives the full corpus in a lump-sum payout (provided that they have invested in the NPS scheme for at least 5 years). These are somewhat challenging terms, and financial experts typically advise against exiting the NPS too early.
In the event of the NPS subscriber’s death, the whole amount is transferred to the family member or to the legal heir.
NPS allows individuals to pick where they wish to invest their money. There are four asset types to consider: equity, corporate debt, government bonds, and alternative assets. The maximum allocation to equities is 75%. The permitted allocation to alternative assets is set at 5%. On the other hand, NPS includes an automated option called ‘Life cycle fund’ that pre-determines the allocation to each asset class based on your age. More volatile asset classes, such as equity are gradually phased out of the portfolio, as people become older.
You can select one of three ‘lifecycle funds’ based on your risk appetite: aggressive, moderate, or conservative. Aggressive funds begin with a maximum equity exposure of 75% until age 35, and then gradually lower it to 15% by the time the investor reaches 55 years old. In a moderate life cycle fund, the maximum equity exposure is 50% until the age of 35, then drops to 10% when the investor reach 55, and remains at 10% beyond 55. In a conservative life cycle fund, the maximum equity exposure is capped at 25% until age 35, and then drops to 5% when you reach the age of 55, and remains at 5% for those 55 and beyond.
NPS subscribers must also pick a pension fund manager from three government enterprises and five private pension managers.
To summarize, the NPS is designed for extremely long-term goals such as retirement. The framework and the fund managers of NPS ensure that the funds are handled in accordance with the subscriber’s retirement needs. We don’t have to be lured by short-term market exuberance when it comes to pension plans; instead, we can be patient and stay in it these pension instruments to reap the rewards after retirement.
