In the last budget, the Finance Minister offered an additional tax benefit of Rs 50,000 per year for investment in NPS. This tax benefit is available exclusively to NPS under Section 80CCD (1B). Moreover, this benefit of Rs 50,000 is over and above Rs 1.5 lacs under Section 80C. For this additional tax benefit, NPS has caught the attention of many investors.
Should I invest that extra Rs 50,000 in NPS to avail that exclusive tax benefit of Rs 50,000? I get this question many times. If you fall in the highest tax bracket, this will mean tax saving of Rs 15,450, which is significant.
If you want to know about NPS in general, you can go through the following post.
All you need to know about NPS
This is an old post but gives you a fair idea of NPS. Refer to updated posts for Tax benefits of NPS and Revised Withdrawal and Exit Rules for NPS.
What should you do? Should you invest Rs 50,000 in NPS for additional tax benefit?
Before I get into whether you invest Rs 50,000 in NPS for that extra benefit, let’s consider some issues with NPS.
Issues with NPS
- NPS falls under EET tax regime. Hence, tax benefit for NPS is essentially tax deferral. You can pay tax now or pay tax later. Doesn’t really matter. The pension income from NPS and lump sum withdrawal from NPS will be taxed at your marginal income tax rate as per the extant income tax laws.
Update: Feb 29, 2016
Under the latest budget proposal, the Finance Minister has proposed income tax exemption for 40% of the NPS maturity amount. Read this post for greater details. This sweetens the deal for NPS investors.
Must Read: Tax Treatment of NPS and Tax Treatment at Maturity (Updated)
- Though NPS withdrawal and exit rules have been made less stringent, the rules offer only minor leeway. For someone looking for early retirement, 80% of the accumulated corpus has to be converted to annuity. What will you do if you are planning an early retirement?
Must Read: Revised Withdrawal and Exit Rules for NPS
- For reasons I have never found easy to comprehend, designers of NPS want to make it a One Stop shop for all your investment needs. So, they want to give you exposure to equity, government debt, corporate debt, real estate etc. Due to this, the low cost structure of NPS is expected to be compromised.
Must Read: NPS likely to get more expensive
- There are other issues too relating to capping of investment in specific asset classes. For instance, equity exposure in Government Sector NPS is capped at 15% while the exposure in private sector (or all citizen model) is capped at 50%. A young professional can do with a higher equity exposure.
NPS is essentially tax deferral. You pay tax now or at the time of retirement. For instance, you invest Rs 50,000 in NPS for 15 years. You are in the highest tax bracket. In 15 years (at 10% p.a.), the amount will grow to Rs 17.47 lacs. If your marginal tax rate is 30%, you will get Rs 12.07 lacs post tax.
On the other hand, if you pay tax on Rs 50,000 every year and invest the remaining Rs 34,550 in any instrument that gives tax-free return of 10%, you will end up with same Rs 12.07 lacs.
The play is on the marginal rate of taxation (income tax slab). If you can somehow manage a lower marginal tax rate at the time of withdrawal (after retirement), you can actually save some money by investing in NPS.
It is in this light that a recent circular by PFRDA on withdrawal of lump sum assumes importance.
Update: Feb 29, 2016
Under the latest budget proposal, the Finance Minister has proposed income tax exemption for 40% of the NPS maturity amount. Read this post for greater details. This sweetens the deal for NPS investors.
PFRDA Circular on Deferred Withdrawal of Lump Sum
In a notification on October 29, 2015, PFRDA clarified that the lump sum amount can be withdrawn in up to 10 annual installments till the age of 70. Please note the installments need not be equal.
This is applicable to both Government Sector NPS and All Citizens model (including corporate sector NPS).
You can download the circular (Clarification of deferred withdrawal of lump sum) from PFRDA website.
How does this Change affect you?
This is an interesting development. Since the lump sum amount can be huge, withdrawing the entire amount at one go would have had serious tax implications. The lump sum amount would have taken you to highest income slab (30%) in the year of withdrawal. Since the withdrawn amount is to be taxed as per income tax slab, the tax liability could have been huge.
However, with this provision of withdrawal in 10 annual installments, you can spread lump sum withdrawal across 10 years to reduce your tax liability in the years of withdrawal.
Illustration
Let’s assume by the time you retire, you have a NPS corpus of Rs 1 crore. You choose to purchase annuity for Rs 50 lacs and decide to withdraw Rs 50 lacs as lump sum.
Though there are multiple annuity products available, let’s assume you opt for annuity for life. Let’s assume further that the prevailing annuity rate is 6% p.a. So, you will get annual pension of Rs 3.0 lacs every year for life. I assume there is no other source of income.
Tax exemption limit for senior citizens is Rs 3 lacs.
If you withdraw the entire lump sum amount in the year after retirement, your income for the entire year will be Rs 53 lacs. You will be taxed at your marginal tax rate. The total liability for the year will be Rs 14.5 lacs. I have assumed you have not availed any tax deductions.
On the other hand, if you spread out withdrawal of this amount across 10 years and withdraw Rs 5 lacs every year for 10 year. I have taken fairly stupid (but simplistic) assumption that your lump sum amount will not grow in the intervening 10 years.
Hence, your income for the next 10 years will be Rs 3 lacs + Rs 5 lacs = Rs 8 lacs. Tax liability for Rs 8 lacs comes to Rs 82,400 per annum. Over 10 years, you will pay tax of Rs 8.24 lacs.
That is a neat saving of Rs 6.28 lacs over 10 years.
With this relaxation by PFRDA, you can reduce your income tax liability to certain extent after retirement.
Points to Consider
- The lump sum withdrawals need not be in equal installments. So, you can withdraw Rs 4 lacs in first year, Rs 6 lacs in second year and Rs 3 lacs in third year. It is up to you. The only limitation is that you can make only one lump sum withdrawal per year.
- I have not considered any tax deductions. Considering tax deductions, you will have even more savings. If you can avail deduction of up to Rs 2 lacs every year (after retirement) through 80C investments or in any other way, savings would be even higher. In such a case, the tax savings would translate to Rs 9.78 lacs over 10 years.
- If you have other source of income, then the benefit of spreading lump sum withdrawal over many years will be nullified. In the aforesaid example, if you had other income of Rs 5 lacs (in addition to NPS pension), there is no tax saving. For one time lump sum withdrawal, you will pay total tax of Rs 23.48 lacs. For staggered withdrawal, you will pay total tax of Rs 21.63 lacs. The reason is higher other income will push you into higher tax bracket for all 10 years.
- Therefore, the extent of tax saving will depend on your NPS retirement corpus, NPS pension amount, other sources of income and deduction availed during post-retirement years. Here is a snapshot of various cases.
PersonalFinancePlan Take
The notification from PFRDA about withdrawal of lump sum in up to 10 installments can help reduce some tax liability after retirement. However, other issues regarding limited withdrawals, cost structure of NPS and investment restrictions still remain. You need to weigh the pros and cons.
There are better Section 80C investments available. You will develop a better retirement portfolio with your regular ELSS, EPF, PPF etc. So, you shouldn’t consider NPS when you are planning to fill your quota of Rs 1.5 lacs under Section 80C.
For the exclusive benefit of Rs 50,000 under Section 80CCD (1B), I don’t have a crisp answer. NPS, as a product, is still evolving. I don’t know how it will shape up. There have been so many changes already in the past 6-8 months.
You can consider NPS (for extra tax benefit of Rs 50,000) if you are in the highest tax bracket. I do not say this with a lot of conviction but I wouldn’t hold it against you for investing in NPS for that extra tax benefit. With some smart tax planning, you may actually be able to save income tax post retirement (and get taxed at a lower income tax rate).
If you are in the lowest tax bracket, then it does not make much sense (from the taxation perspective). You are getting taxed at 10%. At the time of retirement (or age of 60), you are unlikely to manage a lower income tax rate.
I have always maintained investment decisions should not driven by tax considerations alone. Investment in NPS is no different. NPS, to me, is still behind in certain important aspects. Personally, I wouldn’t invest in NPS for the extra tax benefit of Rs 50,000.
What would you do?