The National Pension System is a cost-effective and tax-efficient vehicle to save and invest in for your retirement. The NPS was launched in 2004 for central government employees but is now open to all Indian citizens in the age group of 18 to 65 years of age. Over the years, the NPS rules have been changed to make it more attractive and investor-friendly.
The NPS is governed and regulated by the Pension Fund Regulatory and Development Authority of India (PFRDA).
Unlike public or employee provident fund (EPF), where annual returns are assured and capped for every year, NPS is a market-linked saving and investment instrument where returns can vary every year depending on the movement in the equity and the bond market.
As a market-linked saving instrument, NPS operates like a hybrid mutual fund that invests in various kinds of financial instruments such as equity, government securities, corporate bonds and alternate assets such as real estate and infrastructure funds to maximise the returns for the investors. Bigger exposure to equity and high-yielding corporate bonds translates into higher returns for NPS investors compared to provident funds.
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Under the active choice option, NPS investor has the freedom to design the portfolio by voluntarily distributing investments among four asset classes – equity (E), government securities (G), corporate bonds (C) and alternate assets (A) in a proportion that she finds appropriate. However, the overall exposure to equity cannot exceed 75 per cent of the total portfolio.
If you don’t mention your preference or choice of the fund at the time of registration, your investments will be invested in the default funds handled by the Pension Fund Regulatory and Development Authority (PFRDA). These funds are invested by Pension Fund Regulatory and Development Authority and managed by professional fund managers.
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The third option is to go for a pre-defined auto choice and choose any of three investment styles for your investment – aggressive (75 percent allocation to equity), moderate (50 percent to equity) and conservative (25 percent to equity).
The contribution to the primary NPS accounts (Tier-1) is tax-free up to a maximum of Rs 1.5 lakh per financial year under Section 80C of the Income Tax Act, 1961. Besides, an additional contribution of up to Rs 50,000 also qualifies for tax deduction under Section 80CCD (1B) of the Income Tax Act, 1961.
There are additional tax deductions for the employer’s contribution to the primary NPS account under Section 80CCD (2). The maximum amount eligible for tax deduction under this section is 10 per cent of the basic income plus dearness allowance (DA).
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Lock-ins and withdrawal limits
As mentioned earlier, the money invested in NPS primary accounts is locked-in till you turn 60. After the age of retirement, 60 percent of the corpus can be withdrawn right away and the balance of 40 percent has to be invested in an annuity scheme from any life insurance company. The annuity scheme will provide you with a monthly pension. The 60:40 split between withdrawal and annuity is mandatory under current NPS rules which adds an element of inflexibility to the scheme.
However, on the brighter side, there is no tax on the 60 percent corpus that you will withdraw after retirement. The annuity is added to your taxable income and taxed at the applicable slab rate.
The lock-in and withdrawal limit only applies to funds invested in the Tier-1 NPS accounts. Investors also have the option to open a Tier-2 NPS account which has no lock-in and funds can be withdrawn at any time and works as an open-ended mutual fund. However, no tax benefit is available for contributions made to the NPS Tier-2 account. In the same vein, the withdrawal from the Tier-2 account is added to your taxable income and taxed per your slab rates.
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An investor has to compulsorily invest in a Tier-1 account NPS and then she can open a Tier-2 account and operate it like an open-ended mutual fund.
Fees and expense ratios
The National Pension scheme has the lowest fund management fee and expense ratio among all market-linked savings and investment instruments in India including mutual funds and unit-linked investment plans (ULIPs) offered by life insurance companies.
The total recurring expenses inclusive of the fund management fee and all other handling and administrative charges would work out to be around a maximum of around 0.21 percent per annum for the NPS account. In comparison, the total expense ratio for mutual fund schemes can be as high as 2.5 percent per annum. The lower ratio leads to higher net returns and a bigger retirement corpus for NPS investors.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).
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