Should I invest in NPS? Or Should I invest Rs 50,000 in NPS for exclusive tax benefit under Section 80CCD(1B) and no more? This is a question that worries many of us in the last quarter of financial year. What should you do? Taxation and withdrawal rules have witnessed a massive change in the last few years. How do these changes affect your decision to invest in NPS?
From investors’ perspective, there are a few genuine issues with NPS. On the other hand, there are a few areas which a number of investors think are worrisome but are not in reality.
In this post, I will discuss such aspects of NPS.
What is a problem with NPS?
1. Mandatory purchase of annuity
You must use at least 40% of the accumulated corpus to purchase annuity at the time of retirement. Nothing wrong with the concept per se. Pension plans come with an annuity component attached. Hence, there is nothing special about NPS.
However, annuities are low return products especially if you purchase at a young age. These days, 60 is not too old. Though annuity rates keep on changing, you can get an idea about an annuity rates in this post.
Annuity income is taxed at your marginal income tax rate.
Must Read: Annuity options under NPS
2. Liquidity is a constraint.
You are almost locked in till the age of your retirement. In case of early voluntary retirement, you can either continue with contributions till the age of 60 or you must purchase annuity with 80% of the accumulated corpus (if you want an early exit). If NPS is your major investment, then NPS will govern when you want to retire. Not acceptable.
Partial withdrawal is permitted under NPS for child education/marriage, purchase/construction of house and treatment of critical illnesses. Even this comes with many restrictions on withdrawal amount and timing.
You are almost locked in till your retirement.
Must Read: NPS Withdrawal and Exit Rules
3. Rules are ever changing
NPS is a new product. And rules will keep changing. A few for the better. A few for the worse.
My biggest fear is PFRDA turning out to be something like IRDA. IRDA believes incentivizing the distribution chain to increase penetration. In fact, rewarding will be a better choice of word.
PFRDA recently include a service charge of 0.05% of the contribution amount per annum. I hope PFRDA will not add such charges in the future.
Must Read: You can contribute to NPS even after the age of 60 (All Citizens Model)
What is not a problem with NPS?
1. Taxation of Lump sum Proceeds
Much has been written about taxation of maturity proceeds of NPS.
40% of the accumulated amount is exempt from income and can be withdrawn as lump sum.
At least 40% must be used to purchase annuity. Annuity income is taxed at the marginal income tax rate. Since there is consensus that annuities are bad products, let’s assume you will purchase annuity for no more than 40% of the accumulated corpus.
By the way, annuities can be useful when you are quite old and find it difficult to manage the corpus. You may not have the same physical and mental strength to manage your investments when you are 80. But that’s for later.
Must Read: NPS Tax Benefits and Tax Treatment at Maturity (Post Union Budget 2016)
What about the remaining 20%?
PRFRA permits you to withdraw the remaining 20% in 9 annual installments. The rule is that you can withdraw the amount left after purchase of annuity in 10 annual installments (till the age of 70). Since 1 installment has been utilized to withdraw 40% of the amount, only 9 installments remain. You can refer to concerned PFRDA circular here.
I am sure you can use this provision smartly to reduce your income tax liability.
For instance, you retire at 60. You withdraw 40% as lump sum. You can defer purchase of annuity by up to 3 years. Depending upon the size of corpus, you can withdraw remaining lump sum in 2 installments. Subsequently, you can purchase annuity towards the end of third year.
2. You cannot invest more than 50% into equity.
I don’t think of this as a problem. NPS is not your only investment. You can always compensate by investing more in equity outside of NPS.
In any case, there is a proposal to let investors take greater exposure to equity in NPS.
Should you invest in NPS?
In my opinion, there is no point investing more than Rs 50,000 per financial year. And this Rs 50,000 comes due to the exclusive tax benefit under Section 80CCD (1B).
In fact, there are many experts who argue against even investing this Rs 50,000 in NPS. I do not agree.
It makes sense to invest in NPS for that exclusive income tax benefit under Section 80CCD (1B). More so for people who are in the highest income tax bracket and are sure that they won’t need this money till such time they retire.
Illustration
Let’s say you are 30. You invest Rs 50,000 per annum in NPS for 30 years. Assuming a return of 10% p.a., you will end up with approximately Rs 90 lacs when you turn 60. Now, Rs 90 lacs is so difficult to adjust.
Annuity rate is assumed at 6%.
Let’s see the options at your disposal.
- 40% lump sum withdrawal, 60% annuity purchase
- 60% lump sum withdrawal, 40% annuity purchase
- 40% lump sum withdrawal, 40% annuity purchase, 20% staggered withdrawal
You can withdraw Rs 36 lacs lump sum at the time of retirement. This amount will be exempt from tax.
What is an alternative?
Let’s assume you decided against investing Rs 50,000 per annum in NPS. You have to pay tax on the amount since NPS tax benefit under Section 80CCD(1B) is exclusive. You will have to pay an additional Rs. 15,450 as income tax. You are left with Rs 34,550.
Assuming you invest this amount in equity funds and earn a return of Rs 10% p.a., you will end up with Rs 62.51 lacs at the end of 30 years. I assume long term capital gains from sale of equity funds will still be exempt from income tax after 30 years.
If you compare this amount with second case (60% lump sum and 40% annuity), you end up with Rs 50.64 lacs lump sum (post tax) and annuity incomeRs 2.17 lacs per annum for life. NPS certainly looks like a better option.
You can argue NPS has lower exposure to equity and hence equity funds can earn better returns than NPS. Well, this is a valid point but I will ignore this for now. Who knows PFRDA may actually permit 100% equity investments. And who knows long term capital gains tax on sale of equity funds will start getting taxed after a few years?
In my opinion, as we have seen with EPF and PPF, once NPS becomes popular, it may be difficult to rollback tax benefits.
Please understand I have chosen the numbers (contribution, return, annuity rate) to suit my argument. You are advised to rework the numbers based on your assumptions and assess the impact for yourself.
What about investors in the lowest tax bracket?
If you fall in the lower income tax brackets, then it may not be as fruitful. First, you save less in taxes by investing in NPS. Secondly, NPS may not crowd out your other investments i.e. after investing in NPS you may not have much left to invest anywhere. I am not saying you should not invest in NPS if you fall in 10% and 20% tax brackets. However, you must consider these aspects before making your decision.
Here are the points to note:
- NPS is a smart tax saving choice for investors in 30% income tax bracket.
- Do not invest more than Rs 50,000 per financial year in NPS.
- Do not invest small amounts every month. Contribution charges will eat into your returns. You may be better off investing in 1 or 2 installments.
- NPS must not be your major investment. It should form only a small part of your overall portfolio.
- If you are planning for an early retirement, NPS is not for you.
- Forget about the money you invest in NPS till the age of 60/superannuation. If you can’t, NPS is not for you.
- If you have other sources of taxable income during retirement, then this analysis may not hold true. You must make necessary adjustments before making the decision.