Though I have talked about the difference between Tier 1 and Tier II NPS accounts in many of my earlier posts, I still receive a number of queries from investors asking about the difference between the two.
In fact, I had a query where the investor invested in Tier 2 NPS to avail tax benefit (figured out later).
Therefore, I think it will be useful to dedicate a post to the topic.
At a broader level, You can think of NPS Tier 2 account as an open-ended mutual fund. There are no restrictions on withdrawal from NPS Tier 2 account. However, at the same time, there are no tax benefits either for investment in Tier 2 NPS account.
So, whenever you hear about tax benefits on investing in NPS, they are referring to NPS Tier 1 account only.
Let’s look at the differences between NPS Tier 1 and Tier 2 accounts.
Difference between NPS Tier 1 and Tier 2 accounts
NPS Tier 1 vs. NPS Tier 2 account: Account opening
You can’t open NPS Tier 2 account in isolation. It has to be opened with the NPS Tier 1 account. When you close NPS Tier 1 account, Tier 2 account needs to be closed too.
Please understand both the accounts are linked to the same PRAN (Permanent Retirement Account Number). As per law, you can have only one PRAN. Both Tier 1 and Tier 2 account are linked to the same PRAM.
NPS Tier 1 vs. NPS Tier 2 account: Minimum Contribution
As per current rules, the minimum contribution for Tier I NPS account is Rs 1,000 per financial year. There is no minimum contribution in NPS Tier 2 account.
NPS Tier 1 vs. NPS Tier 2 account: Withdrawals
Since NPS Tier 1 is a retirement account, there are many restrictions on withdrawals (before exit) from this account. You are allowed to withdraw only up to 25% of own contributions after 10 years for kids’ education and marriage, construction of house and treatment of serious illnesses.
There are no restrictions on withdrawal in Tier 2 NPS account. You can withdraw money from the account anytime. You can even withdraw your entire investment in NPS Tier 2 account.
NPS Tier 1 vs. Tier 2 account: Mandatory Purchase of annuity on exit
At the time of exit from NPS, 40% of the accumulated corpus in NPS Tier I account has to be used towards purchase of an annuity plan. If the exit is before retirement (superannuation), 80% of the accumulated corpus in the NPS Tier 1 account has to be used to purchase an annuity plan.
There is no such restriction on NPS Tier 2 (or NPS Tier II) account. You can withdraw the entire amount lump sum.
Tier 1 vs. Tier 2 NPS account: Tax Benefit on Investment
All the tax benefits for investment in NPS are limited to investment in Tier 1 NPS account only. The benefit under Section 80CCD(1), Section 80CCD(1B) and Section 80 CCD(2) is only for investment in NPS Tier 1 account.
There is no tax benefit for investment in Tier 2 NPS account.
NPS Tier I vs. NPS Tier II account: Tax Treatment on Maturity
For NPS Tier I account, at the time of maturity, 40% of the accumulated corpus, if withdrawn as lump sum, will be exempt from tax. At least 40% of the corpus needs to be used to purchase an annuity plan. Annuity income is taxable in the year of receipt.
For NPS Tier II, there is not much clarity about taxation at maturity. Clearly, the tax treatment of NPS Tier I has not been extended to NPS Tier II (NPS Tier 2).
There are a couple of possible options:
- The gains could be taxed as capital gains.
- The gains could simply be added to your income and taxed at your slab rate.
At the moment, I don’t know which one will apply. I have discussed this aspect in greater detail in this post.
NPS Tier 2 vs Tier I account: Transfer
You can transfer your investment from Tier 2 account to Tier 1 account (and not the other way round). Makes sense too. If the transfer from Tier I to Tier 2 were allowed, you could simply transfer your money from Tier 1 NPS to Tier 2 account and withdraw from the account. NPS Tier I would cease to be a proper retirement savings account.
Here is a recap:
About investment in NPS Tier I, purely from the point of view of taxation, investment up to Rs 50,000 per annum may be a good choice for investors in the highest tax bracket. But yes, there are other issues around NPS Tier 1 that you need to be comfortable with before investing.
I see no reason for investing your money in Tier 2 NPS account.