ELSS vs NPS: Which is better to save tax and grow your wealth?

When the NPS was opened to the general public 10 years ago, the scheme was not very tax friendly. It was also governed by rigid rules. However, over the past 10 years, the government has offered more tax benefits, relaxed investment norms and made withdrawal rules more lenient.

Even so, investors are not really flocking to invest in NPS. More than half of the total 1.24 crore NPS subscribers are central and state government employees who are compulsorily invested in the scheme. Another 44 lakh (or 35% of the total subscribers) are investors in the NPS Swavalamban where the government contributes a small amount. In a country of 130 crore people, only about 17 lakh have voluntarily subscribed to a scheme that has all the ingredients of a good retirement plan.

The villain? The low commissions paid to distributors of the scheme are hardly any incentive to sell the NPS. “Till the NPS increases the commissions payable to distributors, buyers will continue to flock to other products,” chuckles the marketing head of a private insurance company.

Data shows that investing in equity-oriented and market-linked instruments has the highest probability to make you rich in the long term. That would make mutual funds the obvious choice. But the NPS also has very low charges and offers significant tax benefits under three different sections of the Income Tax Act.

This week’s cover story compares the NPS and the ELSS on five major parameters. Read on to know which is the better option for you.

• Returns

ELSS can outperform in the long run

ELSS funds are pure equity schemes that maintain a very high exposure (over 90-95%) to equities throughout the tenure. But NPS investors can’t allocate more than 75% of the corpus to equity funds. Even the 75% equity exposure by aggressive investors gradually tapers off as the person grows older.

This is why ELSS investors have gained more than NPS investors in the past 3-5 years. “A pure equity instrument will deliver better returns than a multi-asset offering over the long-term,” says Ankur Maheshwari, CEO, Wealth Management, Equirus Capital.

How NPS invests your money
Under Active Choice, investors can decide own asset mix.

The picture is different in the short-term. ELSS funds have risen barely 4% in the past one year, while NPS equity funds have delivered double-digit growth. This is because ELSS funds invest across market segments. Even the most cautious ELSS fund manager has about 10-15% of the corpus allocated to small-cap and mid-cap stocks.

On the other hand, NPS equity funds have a decidedly large-cap orientation. “The correction in small and mid-cap stocks in ELSS portfolios has pulled down their returns, while large-cap oriented NPS funds have done well,” says Raj Khosla, Managing Director, MyMoneyMantra.

Returns of NPS funds
Debt funds have also done well over the long term.

NPS returns compared with ELSS
ELSS scores over NPS in the long term but NPS cushions volatility.

However, this could change in the longer term. The multicap orientation of ELSS funds has a greater potential to beat the market and generate alpha over a longer period. On the other hand, NPS funds invest in a limited universe, lining their portfolios with index stocks.

Only recently they have been allowed to invest in scrips in the futures and options segment. “We don’t want the funds to take inordinate risks to generate alpha. Therefore, they are allowed to invest only in index stocks and scrips in the F&O segment,” says Hemant Contractor, Chairman, Pension Fund Regulatory and Development Authority.

• Taxability

ELSS tax is manageable, but pension fully taxable

The tax treatment of both ELSS and NPS has undergone a sea change over the past year. Long-term capital gains from equity funds were tax-free till last year but gains over Rs 1 lakh in a financial year are now taxed at 10%. Meanwhile, the taxability of the NPS has moved in the opposite direction. Earlier, only 40% corpus withdrawn at the time of agretirement was tax free and the remaining 20% was taxed at normal rates. Now, the entire 60% is tax free.

However, the pension from the remaining 40% put into an annuity will be fully taxed as income. In case of ELSS, deft tax planning of capital gains can reduce the tax. But the tax on annuity from NPS is unavoidable. “The tax benefit under NPS amounts to a deferment of tax, rather than complete tax exemption,” points out Rohit Shah, Founder & CEO, Getting You Rich.

Both ELSS and NPS are eligible for tax deduction. Up to Rs 1.5 lakh put in ELSS gets deduction under Section 80C. NPS investments are also eligible for deduction under Section 80CCD(1) with an overall ceiling of Rs 1.5 lakh under Section 80C. But NPS investors get additional deduction of up to Rs 50,000 under a new Section 80CCD (1B). In the 30% tax bracket, this means additional tax savings of Rs 15,600.

Tax benefits of ELSS and NPS
NPS can save tax in three ways

• Section 80CCE: Up to Rs 1.5 lakh
• Section 80CCD(1B): Up to Rs 50,000
• Section 80CCD(2): Up to 10% of basic

ELSS can cut tax under Section 80C: Up to Rs 1.5 lakh

That’s not all. Salaried individuals can claim more deduction if their employer puts up to 10% of their basic salary in the NPS under Section 80CCD(2). There is no cap on this deduction. If your basic salary is Rs 50,000 per month and you are in the 30% tax bracket, you can reduce your tax by almost Rs 18,720 if your company contributes 10% of the basic in the NPS. “If your company offers NPS, don’t miss the opportunity to cut your tax,” says Archit Gupta, CEO of tax filing portal Cleartax.in.

• Flexibility

ELSS allows withdrawals, NPS allows switching

As mentioned earlier, ELSS funds invest only in equities, while NPS invests in a mix of equities, government securities, corporate bonds and alternative investments. Investors can choose their own asset mix if they are confident of making the right choice. Otherwise, they can opt for lifecycle funds where the asset mix changes as the individual grows older. Three lifecycle funds - aggressive, moderate and conservative— cater to investors with different risk appetites. For people who are not well versed with market vagaries, the gradual decline in equity exposure protects the corpus against volatility as their retirement date comes nearer.

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NPS investors have a choice of three lifecycle funds

ELSS funds have a lock-in period of three years. Even if the fund is doing badly or the market is looking jittery, you can’t touch the money before three years. But NPS allows investors to switch to another pension fund or change the asset allocation, though only two such switches are allowed in a financial year.

There’s another difference. An individual can spread his investments across as many ELSS funds as he wants. The NPS doesn’t allow such diversity. The investor has to go with just one pension fund for handling his entire corpus.

ELSS investors can invest in driblets of Rs 100 per month. But if NPS investors invest very small amounts, they will end up paying a very high amount in transaction fee. The transaction fee is Rs 20 or 0.25% of the contribution. If investing Rs 500 per month, the Rs 20 transaction fee will be 4% of the contribution.

Some financial advisers feel that NPS should add a liquid fund option for those who are about to retire. “Equity markets are volatile but even debt markets can lose money. NPS investors should be allowed to shift to a liquid fund after 55 years where they will earn low but positive returns,” says Deepti Goel, Associate Partner, Alpha Capital.

• Liquidity

ELSS locked for three years; NPS till retirement

Once the lock-in period is over, ELSS investors can withdraw their funds and even stop investing altogether. The NPS has a much longer horizon. In normal circumstances, you can withdraw only at the time of retirement or when you turn 60, whichever is earlier. Partial withdrawals are allowed only for specific reasons like child’s higher studies and marriage or treatment of critical illness. But you can do so only three times during the entire tenure of the subscription and only if you have completed three years in the NPS.

“Investors should be very clear that the NPS money is for retirement planning because it is not possible to withdraw before that,” says Amol Joshi, Founder, PlanRupee Investment Services. Even on retirement, only 60% of the corpus can be withdrawn as lump sum. The balance 40% is compulsorily put in an annuity to get a monthly pension. “Effectively, 40% of the corpus is unavailable to the investor upon retirement,” says Hemant Rustagi, CEO, Wiseinvest Advisors.

Only if the total corpus is less than or equal to Rs 2 lakh, can the subscriber withdraw the entire amount. Subscribers can exit prematurely from the NPS if the account has completed 10 years. But in that case, the subscriber can withdraw only 20% of the amount lump sum and the remaining 80% will be put in an annuity to provide a monthly pension.

Some experts feel that the low liquidity offered by NPS is actually a plus point. ELSS can create wealth only if you invest regularly and hold for the long term. “If you are prone to dipping into your savings, the NPS is a better option because of the restrictions on withdrawals,” argues Shah.

• Costs

Despite multiple charges, NPS is much cheaper than ELSS Mutual funds have a fairly simple cost structure. It is represented by a single number in the form of the total expense ratio (TER). The TER is deducted from the fund’s NAV on a daily basis. Regular plans of ELSS funds have a TER of around 2.4%, but direct plans bought without a distributor are cheaper by almost 75-100 basis points.

How NPS charges investors
While it is the cheapest investment product available in India, the NPS levies multiple charges, including an entry load on every contribution
*Asset servicing charges and reimbursement of expenses

Still, they cannot match the ultra low-cost structure of the NPS. At 0.01%, the fund management charge of the NPS is among the lowest for equity-linked instruments. However, this is not the only expense for the investor. NPS has different layers of charges, including one-time charges at the time of on-boarding and a flat fee payable for every transaction.

Mutual fund distributors insist that NPS investors should play closer attention to the costs. “Unlike ELSS, all the NPS charges are not built into its NAV. So the actual return for the investor may vary from the fund performance,” says Joshi. Despite the complex web of charges and deductions, the NPS still works out to be cheaper than even the direct plans of ELSS funds.

What investors should do
Given its high equity exposure, ELSS should be the primary vehicle for long-term wealth creation, suggest financial planners. “If one’s risk profile permits, ELSS is best suited for wealth creation in the long run,” asserts Maheshwari. Those who have not exhausted their Sec 80C limit of Rs 1.5 lakh should first go for ELSS, and utilise the additional NPS window up to Rs 50,000.

Having said that, please note that investment choices should not be guided merely by tax savings. Investors should also consider how an instrument fits into their overall financial plan, asset allocation and risk profile. NPS suits those who are not comfortable making investment decisions on their own. The auto choice in lifecycle funds provides a tailor-made solution for such investors.

But this is not a binary between NPS and ELSS. Planners contend that both products can complement each other in the long-term portfolio. “There is space for both products in a portfolio,” argues Suresh Sadagopan, Founder, Ladder 7 Financial Advisories. NPS can be a strategic investment geared towards retirement, while ELSS can be used as a tactical avenue for other interim goals.