Over the year and a half, NPS has attracted many new investors to its fold because of exclusive tax benefit of Rs 50,000 under Section 80CCD(1). Union Budget 2016 made the withdrawal at the time of retirement more tax friendly.
Do you know these tax benefits are only limited to NPS Tier I account? What about investment in Tier II NPS account? Well, not many bother.
Though NPS Tier II does not get much attention because there is no tax benefit on investment, it presents an investment alternative nonetheless.
In this post, let’s discuss the tax treatment of NPS Tier II investments and if you must consider NPS Tier II for your investments.
Can I open a Tier II NPS account without opening Tier I account?
You cannot open a standalone Tier-II NPS account. You need to open a Tier I NPS account before you operate Tier II NPS account.
Liquidity in NPS Tier II Account
There is no restriction on withdrawals from NPS Tier-II account. You can withdraw the amount whenever you want.
Must Read: Revised Exit and Withdrawals rules for NPS
Tax Benefit on Investment in NPS Tier II Account
There is no tax benefit on investment in Tier-II Account of NPS.
All the tax benefits on investment under Section 80CCD are limited to Tier I account of NPS.
Tax Treatment of withdrawal from NPS Tier II account
Better clarity is awaited on this matter. There can be 3 potential treatments.
1. Should be given the same treatment as Tier-I NPS
Under Tier I NPS, up to 40% of accumulated corpus is exempt from income, if the amount is withdrawn as lump sum. This was announced in Union Budget 2016.
Do note you can withdraw up to 60% of the accumulated corpus as lump sum at the time of retirement. However, only 40% is exempt from tax.
You may argue that NPS Tier II should be extended the same treatment.
Let’s look at Section 10 Act mentions post the passage of Income Tax Act.
(12A) any payment from the National Pension System Trust to an employee on closure of his account or on his opting out of the pension scheme referred to in section 80CCD, to the extent it does not exceed forty per cent of the total amount payable to him at the time of such closure or his opting out of the scheme;
Quite clear. The announced relaxation is only for Tier-I NPS account because contribution to only Tier-I NPS enjoys tax benefit under Section 80CCD.
2. Should get capital gains treatment
NPS Tier-II is like an open ended mutual fund. Hence, it should get a similar tax treatment. Redemption from Equity scheme (E) of NPS Tier II shall get tax treatment of an equity fund.
Redemption from Government Bond (G) or Corporate Bond scheme (C) shall be taxed like redemption from debt mutual fund.
However, for that to happen, NPS Tier-II must qualify as Capital Asset under Section 2. I am not sure if it does.
3. Withdrawals to be taxed at marginal income tax rate
The entire withdrawal/redemption amount shall be taxed at your marginal income tax rate. To be honest, this looks onerous. This may amount to double taxation. You invest in Tier-II NPS from your post tax income (since there is no tax benefit on investment).
At the time of withdrawal, the entire withdrawal amount gets added to your income and gets taxed at your marginal income tax rate.
Which taxation option will apply?
I don’t know. Option 1 is certainly out of picture.
The choice must be between Option 2 and 3.
You can expect better clarity to emerge over the next few years.
You incur cost to invest in NPS Tier II
You need to pay 0.25% of the contribution amount every time you invest in NPS Tier I or Tier II account. Service tax shall be extra. This charge is NOT applicable if you make contribution through eNPS portal.
However, there can be payment gateway charges if you are investing through eNPS. Payment through credit card or debit card can result in charges up to 0.9% of the contribution amount. If you pay through net banking, it is quite cheap at 60 paise per contribution.
If you plan to invest through NPS, contribute through eNPS and use Net Banking to save cost.
Should you invest in Tier-II NPS?
My answer is No for the following reasons.
There is not much clarity on how the withdrawals from NPS Tier-II will be taxed. Perhaps, better clarity will emerge over the next few years. You can see Option (3) spells big trouble.
Even with lower expense ratio, you must consider the all-in cost of investing in NPS Tier-II. There are multiple ancillary charges that may take the overall cost of investment higher.
Stay away from Tier-II NPS for the time being. You are better off investing in mutual funds on your own.