With NPS almost EEE, should you now invest in NPS?

The tax regime for NPS has gotten better and better over the last few years. In December 2018, the Government has almost given EEE (Exempt-Exempt-Exempt) tax status to NPS.

Is NPS really EEE?

NPS has almost attained EEE (Exempt-Exempt-Exempt) tax status. This is in line with the other popular retirement products such as EPF and PPF. However, there is still some difference. With EPF and PPF, you get the entire amount tax-free. Under NPS, at least 40% has to be used for purchasing an annuity plan and the annuity income is taxed at your slab rate.

Here is how you have to use for accumulated corpus in NPS at the time of retirement

1. You must use at least 40% of the accumulated corpus to purchase an annuity plan. By the way, you can even use the entire amount. The annuity income in the future years is taxed at your slab rate.
2. Up to60% of the accumulated corpus can be withdrawn lumpsum at the time of retirement. The entire 60% is now exempt from tax. By the way, the rules permit investors to take out the money in up to 10 annual investments (till the age of 70). If you go through my earlier posts, I had mentioned that investors could have used this option to reduce their tax liability. However, with the new tax rule, this is not important from tax perspective.

Do note, in my opinion, the new tax rules about NPS will be effective only from the next financial year (FY2020). Therefore, if your NPS exit is looming, you may wait for a few more months to avoid this tax uncertainty.

What are the problems with NPS?

I have highlighted issues with NPS before and the issues with NPS have not just been limited to its taxation. There are issues pertaining to liquidity, flexibility, double incidence of cost (taken care of now), mandatory purchase of annuity, frequent changes in investment guidelines etc.

By the way, mandatory purchase of annuity at retirement is not very bad.  Smart purchase of annuity plans can cover your longevity risk (you outliving your retirement corpus).  The issue is that you do not get a good an from annuity plans (especially at the not very old age of 60). However,you have an option to extend your NPS account till the age of 70. Therefore, if you have planned your other investments for retirement well, you can reduce the disadvantage due to the mandatory purchase of an annuity plan.

Till now, I have advocated that you can invest in NPS provided:

1. Your marginal tax rate is 30%.
2. You are NOT planning an early retirement.
3. You can afford to forget about the money till the age of 60. Can you really do that?
4. NPS is NOT crowding out your other investments.
5. NPS is not your major investment for retirement.
6. You do not invest more than Rs 50,000 per annum in NPS. The cap is because the exclusive tax benefit for investment in NPS is capped at Rs 50,000 per annum.

Even with the favourable tax changes, I will stick with the same suggestion.

Why not invest more than Rs 50,000 in NPS?

During the calendar year 2018, there have been important developments on the taxation front.

1. Long term gains on Equity investments (direct equity and equity mutual funds) used to be exempt from tax. However, from FY2019, LTCGon sale on equity/equity mutual funds is taxed at flat 10%.
2. Only 40% (out of the maximum 60%) of the lumpsum withdrawal from NPS at the time of retirement used to be exempt from tax. Now, the entire 60% is exempt from tax.

With the equity investments not taxable at 10% (LTCG), the supporters of NPS may argue that NPS may be a very good way to take equity exposure since the proceeds will be exempt from tax. With NPS, you can rebalance your portfolio ina much more tax-efficient manner. In that case, why limit only to Rs 50,000 per annum? Why not invest more to benefit from this tax arbitrage?

Personally, I am not comfortable investing more than Rs50,000 per annum. The lack of liquidity and flexibility with NPS is one of the major reasons. Remember, your money in NPS is virtually locked in till the age of 60. If you exit before the age of 60 of superannuation, you will have to purchase an annuity plan for 80% of the accumulated amount(and not 40% in case of normal exit at 60). After some time, the regulator may bring in some other investment guidelines, which you may not like. In such a case, it is advised that you do not bank completely on NPS for your retirement.

In a way, tax benefits (subject to meeting the conditions mentioned earlier) can push me to invest in NPS up to Rs 50,000 but not more.

How do the numbers look?

There is clear tax-saving under Section 80CCD(1B) for investing in NPS. If you skip NPS and invest elsewhere, you will have to pay tax on the amount and only the post-tax portion will be available for investment. For instance, if you are in 30% tax bracket and youskip investment of Rs 50,000 in NPS, you will have to pay a tax of Rs 15,000. After cess of 4%, it goes up to Rs 15,600.

You could have invested Rs50,000 in NPS. You passed the offer and can now invest only Rs 34,600 in say, equity funds.

Let’s see how the corpus will grow. I have considered an investment duration of 30 years. In the first example, I have considered equal returns in NPS and equity funds. I picked equity funds since we are investing for the long term.

One of the concerns is that the NPS returns may not be as good as equity or equity hybrid funds. In the second case, I have considered a higher rate of return of 11% for equity funds.

I leave it to you to interpret the numbers.

There are clear flaws in the way I have done these comparisons. Comparing a hybrid fund like NPS to pure equity funds is not really a like-to-like comparison. Moreover, there is no reason for me to believe that equity funds will deliver better returns than NPS (except for their greater equity nature). At the same, now youcan go up to as high as 75% in equity in case of NPS. With the added benefit of tax-free annual auto-rebalancing in NPS, you may end up earning less volatile returns in NPS.

You can also argue, why 10% and 11%, why not 12%. Sure, you can pitch in your return expectations and see the difference.

By the way, I looked up the return of NPS pension funds (NPS Tier 1 Equity funds) onValueResearch website. The returns looked quite comparable to an average large cap fund.

The average large cap equity fund returns (as per ValueResearch)are 11.63% p.a. over 3 years and 12.31% p.a. over 5 years. I have considered point-to-point returns. You may argue, given the low expense ratio permitted for NPS funds, the NPS equity funds will behave like index funds. For me, that is not a concern since I don’t mind indexing in the large cap space. If you are considering investing in NPS, you must be comfortable with indexing too. You can view the portfolio disclosures on various NPS funds at this link.

Please understand I have only shown Tier 1 Equity returns (E). When investing in NPS, you can also take exposure to Corporate (C) and Government Bonds (G).

For investors in the lower tax brackets (especially 5%), they must note investment of Rs 50,000 in NPS per annum may crowd out their other investments. I believe such investors would also want their investments to be more liquid. Moreover, the impact of tax benefit is also lower, as you can see in the illustrations.

Should you invest in NPS?

My suggestion remains the same. The favourable tax change has made NPS more attractive as a tax-saving avenue.

You can invest up to Rs 50,000 per annum in NPS (Tier 1 account) provided

1. Your marginal tax rate is 30%.
2. You are NOT planning an early retirement.
3. You are sure that you wouldn’t need the money till the age of 60.
4. NPS is NOT crowding out your other investments.
5. NPS is not your major investment for retirement.

By the way, the Government has brought tax benefits under Section 80C (and not 80CCD(1B)) for investment in Tier 2 NPS. Makes little sense to me. Don’t invest in NPS Tier 2.