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    Looking at NPS for tax saving? Find out if the investment suits your financial profile

    Synopsis

    If you are looking to invest in NPS merely to save tax, you need to weigh its pros and cons as it is more of a retirement focused investment.

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    Presently, the fund management charge for NPS is 0.01 per cent of the funds, just Rs 100 to manage a corpus of Rs 10 lakh.
    National Pension System (NPS), a voluntary, defined-contribution retirement savings scheme, with returns linked to market is fast emerging as a popular tax-saving investment. But someone looking to invest in NPS merely to save on tax, needs to weigh its pros and cons since it is more of a retirement focused investment and comes with its share of restrictions.

    The single most important advantage that the NPS has had since its introduction is its low cost. Currently, the fund management charge is 0.01 per cent of the funds, just Rs 100 to manage a corpus of Rs 10 lakh. A low fund management goes a long way in creating a big corpus by eating that much less into the returns generated.

    The other important advantage NPS has albeit partially is on the taxability of the corpus. While up to 60 per cent of the maturity corpus can be withdrawn as a lump sum on maturity at age 60, the balance is compulsorily annuitised, i.e. balance is used to fund the annuity (pension) after retirement.

    In Budget 2016, maturity corpus was made partially tax-free by giving tax-exempt status to 40 per cent of the corpus amount. This made NPS, a mix of EET (60%) and EEE (40%). This annuity is fully taxable in the year of receipt as income from other sources. Going forward, entire 60 percent on vesting age is proposed to be tax-exempt.

    Whom does NPS suit
    NPS suits those who are looking to save for their retirement but are not very comfortable in making investment decisions on their own. Not everybody is in a position to cull out the right investment options on a regular basis over 25-30 years of working life. In short, those who don't want to actively manage their retirement portfolio of debt and equity, NPS is, perhaps, the answer.

    Remember, for someone joining NPS at age 30 and investing for retirement for another 30 years with life expectancy of, say, 90, nearly six decades of active investment management is required.

    So, before you go ahead and invest in NPS for tax saving, see, under which section of the Income Tax Act, would you want to take the benefit, as under:

    Tax benefits for NPS
    At the investment stage, NPS offers the tax benefits under different sections of the Income Tax Act - Section 80CCD (1), Section 80CCD (1b) and Section 80CCD (2).

    Under Section 80CCD (1): Investment up to Rs 1.5 lakh into NPS in a financial year is eligible for deduction under Section 80CCD(1). This deduction comes under the overall ceiling of Rs 1.5 lakh for deduction under Section 80C.

    Under Section 80CCD (1b): In budget 2016, the government had introduced additional tax benefit for investment up to Rs 50,000 in NPS. If the taxpayer contributes more than Rs 1.5 lakh to the NPS in a year, the amount in excess of Rs 1.5 lakh can be claimed as a deduction under the new Section 80CCD(1b).

    Under Section 80CCD(2): Over and above the ceiling limit of Rs 1.5 lakh provided under Section 80C and limit of Rs 50,000 under Section 80CCD(1B), contribution from the employer up to 10% of Basic Salary + Dearness Allowance is also eligible for deduction under Section 80CCD(2). There is no upper cap (in terms of amount) on this tax deduction and it is available only to employees.

    As it is said - No investment product is good or bad, it's just that the features of a specific investment may not suit every investor. So, merely investing in NPS for saving taxes may throw nasty surprises later on.

    Here are 9 important things to watch out for, before investing in NPS.

    Corpus is only partially tax-free
    At age 60, maximum 60 per cent of the corpus can be withdrawn while annuity is paid on the balance 40 per cent of accumulations. Although, maturity corpus was made partially tax-free by giving tax-exempt status to 40 per cent of the corpus amount, the balance 20 per cent of the corpus that can be withdrawn still remains taxable. However, it has been proposed to make it tax-exempt too. One may, however, defer the lump sum withdrawal till age 70, or to avoid paying taxes on this balance, one may club it with 40 per cent annuitisation amount to buy annuity.

    Funds get locked in for long
    NPS is a retirement-focused investment scheme. Typically, there are two stages for someone who wants to accumulate funds for retirement. First is the accumulation phase during which one keeps investing till the vesting age, i.e., the retirement age, and the other is the de-accumulation phase when one starts getting the annuity or the pension.

    Anyone between 18 and 60 can join NPS. Once NPS matures at age 60, payouts happen in two ways: One, a lump sum withdrawal of up to 60 per cent of the corpus can be made, and second, annuity begins on the balance till lifetime. Anyone joining at, say, age 30 will have to continue with NPS during the accumulation phase, i.e. till 60. Also, nearly 40 per cent of the corpus will be unavailable to him for the entire lifetime. It's only the annuity that one receives during the lifetime.

    No 100 per cent equity option
    Saving for retirement is a long-term goal. Several studies have shown that equities have delivered high inflation-adjusted return as compared to other assets such as debt, gold, and real estate, over long-term. NPS currently offers a choice to invest 75 per cent of investment into equity under the scheme E fund option. About 50 per cent of one's investment in NPS even in the scheme E fund option is into debt. In addition, young investors are now allowed to allocate up to 75% of the corpus to equities through the Aggressive Lifecycle Fund (LC-75).

    Lack of active fund management
    NPS fund management currently follows a passive approach. Various NPS funds track different indices. Alternatively, one may invest through a mix of actively traded open ended equity and debt mutual funds during the accumulation phase to create a corpus. The Pension Fund Regulatory and Development Authority (PFRDA) is, however, considering active fund management in near future.

    Compulsory annuitisation hampers diversification
    On the vesting age (maturity age) in NPS, minimum 40 per cent of the accumulated corpus has to be compulsorily invested in an Immediate Annuity scheme which has to be purchased from an insurance company. The amount gets locked in for lifetime.

    Illustratively, if one creates a corpus of Rs 50 lakh in NPS, then Rs 20 lakh (40 per cent, if exiting NPS at age 60, and 80 per cent if exiting before age 60) will be used to buy Immediate Annuity scheme that will fetch pension for lifetime. The amount of Rs 20 lakh will never be returned to the individual. there are however options for the return of corpus amount to family members but they would carry lower pension amount.

    NPS does not give an option to deploy the entire corpus in any other investment avenue as per choice. A retiree may want to deploy the amount across investment avenues such as Senior Citizen Savings Scheme (SCSS), post office monthly income scheme, mutual funds, bank fixed deposits, etc., and across maturities for better liquidity. By opening an NPS account, this flexibility is lost.

    Given a choice, one can use a portion of his retirement kitty for the Systematic Withdrawal Plan (SWP), a feature in mutual funds to withdraw and meet regular income needs during retirement. SWP can be used in all MF schemes, including liquid, bond and equity funds. The effective post-tax yield from them could still be higher than annuities.

    Annuity is taxable
    Annuity is entirely taxable in the hands of the individual in the year of receipt. The income in the form of pension, therefore, adds up to the tax liability of the retiree. On the other hand, dividends from mutual funds are either tax-free (equity-oriented) or have lower incidence of taxation (indexation benefit on non-equity funds). A retiree, depending on mutual funds for post-retirement need, may create a stream of regular income through a judicious mix of funds, including SWP. Above all, the corpus remains liquid.

    Portion of principal get taxed
    A portion of the annuity received also includes the investor's own capital, i.e., savings made during the accumulation phase. Taxing the annuity means paying tax on one's own investment and not merely on the income earned. The amount of pension that one gets when adjusted to inflation is almost equal to the amount one saves during accumulation phase. One, therefore, is merely deferring taxes during accumulation phase as annuity is fully taxable.

    Corpus used for annuity is not returned
    By its very nature, an immediate annuity product does not have the provision of return of capital to the investor himself. The corpus or the amount used to purchase annuity is never returned to the individual. There are about seven to 10 different pension options, including pension for lifetime for self, after death to spouse and post that the return of corpus to heirs. The corpus is not returned to the investor ( but may go to family members) under any pension option.

    Low annuity returns
    The annuity returns across various pension options are currently at around 6 per cent per annum. Such low returns will hardly be able to beat inflation. In decreasing interest rate scenario, these may appear fine, unless insurers revise them downwards. The rates are guaranteed for the entire term of the pension option as chosen by investor.

    Conclusion
    It is a very long-term investment product, so make sure you understand the implications and the working of NPS before opening an account. Estimate the amount of monthly savings required to meet your post-retirement expenses, keeping the inflation and your life expectancy in mind. Diversify across various investments, including mutual funds and NPS, but do not bank entirely on the latter.

    Annuities can provide a baseline support to meet household during retired years and for that a corpus can be created through a mix of mutual funds which can still buy you an Immediate Annuity scheme when you are 60, with all your savings at your disposal. For passive investors, NPS may still be an option to consider but after understanding its working as it is a long term investment.
    ( Originally published on Jan 25, 2017 )

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